Forex Trading – A Simple Guide to Managing Spreads, Trading Expenses & Commissions
by John Arnold
In recent years, one of the most rapidly growing markets for trading has turned out to be the Forex market. The experienced campaigners have always viewed it as a way to maximize their returns. Now, even individual investors are indulging in the Forex market just like they do with stocks and future assessments.
The perception of Forex among individuals is changing rapidly. Previously, it used to be seen as a cool way to diversify a portfolio. Once the investors actually began to learn the ropes, they swiftly came to the conclusion that it is an extremely profitable component within their overall investment choices. This is because the Forex market offers quite a few advantages which sets it apart from the rest:
1. Liquidity without Equal: Nearly $2 Trillion is being traded on a daily basis which makes it THE world’s largest financial market.
2. Superior Potential for Leverage: A leverage ratio of 100:1 can be accessed by individual investors, sometimes even 200:1.
3. Little or no expenses in the form of commissions.
4. And meagre costs for trading.
As the heading of this article suggests, let’s focus on the last 2 points.
Any type of trading involves a few costs or expenses which are relatively low right now. Nonetheless, they have to be understood. I guess the natural starting point would be to consider the trading of stocks, as this is a concept that most investors are very comfortable with.
Investors who are involved in the trading of stocks usually have a trading account setup with a broker. Naturally, their investment funds are deposited in that particular account. In return for suitable compensation, the broker will undertake and execute trades as a representative of the account holder. Usually, the broker earns a commission for going through with a trade in the form of a fixed charge per trade, or a certain figure per share or a tiered commission structure based on the size of your trade. And the charge is incurred on both sides, i.e. you get charged separately for when you buy the stock as well as when you sell it.
On the other hand, the brokers in Forex trading don’t take a commission expect for a few who charge it. Instead of rendering their services for free, they need to make a little money as well. What really sticks out is the way they do it. They charge an investor by a spread, which is the gap between the bid price and the ask price for the currency in question. The broker will add this spread or gap to the price of the complete trade and retain it as her/his fee for the transaction.
It is not exactly a commission, but it pretty much serves that exact purpose by being a little more subtle. On the positive side, you only get charged ONCE. It is usually charged on the ‘buy’ side of the trade and not charged twice. The spread can be written away as a cost of Forex trading and you can decide between various brokers based on what they offer.
The spreads on offer can differ significantly when you compare one broker to another. Initially, you might not notice much difference between a 5 pip & a 4 pip spread. But if you do begin to trade in large volumes or for a long time, that small difference becomes a burden quite fast. There is a 25% difference on your trading costs when the choice is 4 or 5 pips.
Another factor to consider is that spreads vary based on the currency you are trading and the type of account you open. Brokers tend to propose spreads based on the currency. Popular currency pairs like EUR-USD and GBP-USD usually have the lowest spreads while unfashionable currencies are likely to have a higher spread. So make sure you keep yourself in the loop when it comes to the currencies you will be trading in as well as their respective spreads.
Different types of accounts might also encourage brokers to propose varying spreads. For example, a full contract account might elicit a lower spread while a mini-account might attract a higher margin. Because spreads are just the difference between bid prices and ask prices as dictated by the free market, they cannot be considered as compulsory. During periods of low demand, the spread widens and your expenses might pile up. But situations like this are rare as the Forex market is so huge that the demand-supply scale is usually predictable.
To summarize, make sure you are comfortable with the concept of the ‘spread’, as this is the most important factor influencing your trading expenses. Spreads are dependent on brokers, type of account and the currencies in question. And even a small difference in the spread can end up costing you a lot over a longer duration of time.
To conclude, make sure you know what currencies you will be trading in, the frequency of your trades and the type of account you open. Utilize these factors to settle upon a particular broker who might make the optimal proposal which aligns with your interests.