The Hidden Costs of Spot Forex Trading

07/05/2010 12:01 am EST

Focus: FOREX

Sam Evans

Instructor, Online Trading Academy

For the purpose of this article, I would like to highlight an aspect of forex trading which is often the very last thing on the minds of traders: The cost of doing business. As is widely known, if one participates in the equity or futures markets, there is always a commission charge for taking a trade. This charge pays the broker for allowing the position to be taken in the first place. While there is a difference in commission charges among the various equity and futures clearing firms, the charges issued to traders of these markets are widely competitive across the board, especially if the speculative trader is using true direct market access, or DMA, to place their trades. However, when it comes to forex trading, the situation is slightly different in that traders do not pay a direct commission to the firm, but rather are faced with a spread on the currency pair(s) that they choose to trade.

This spread varies among currency pairs, but the structure is always the same across every forex broker and given price quote at any time. There will always be a market price for the pair, and wrapped around this price will be the bid price and the ask price. In essence, we need to think of the buying and selling process in the forex arena as something like an auction environment. No matter what the market price is, there will always be willing buyers and willing sellers available at any time. Those out there are essentially looking to purchase from someone who owns the pair, and the willing or hopeful sellers are looking to sell to someone who is keen to buy. In practice, therefore, the ask is the price you would have to pay to go long, and the bid is the price you would have to sell at to go short. It is this difference between the bid and the ask that we call the spread, and the broker you are using for your forex trading is pocketing this as their "commission" for providing you with a liquid market to participate in.

There are two main aspects of the spread that any responsible and professional forex trader must pay attention to in their trading career. Firstly, we need to recognize that currency trading in the spot market, where this spread is commonly found, is not the ideal arena for scalping methods. Scalping involves entering the market with a very tight stop loss and looking to exit the trade with profit after just a few pips of movement. Now this can be very profitable for the skilled trader with highly developed execution skills, however, to the novice it can result in consistent small losses, which add up greatly over time. Even if you are a seasoned scalper of the market, you still need to be aware that the spread on the asset you are trading is going to heavily influence your potential for making money. If each time you enter the market you are paying a three-pip spread, then this needs to be factored in. So in essence, if you are looking to risk five pips to make five pips on a scalping trade, you would actually need to make eight pips of profit to cover the spread you are paying every time you pull the trigger to enter a new trade. With this in mind, it becomes impossible to just simply buy and then quickly sell for profit, as the forex brokers' spread will always cost you money, and just clicking the button twice in succession will drain your account of capital.

There are, however, some currency pairs that move in huge ranges on a day-to-day basis in comparison to others. While I admit that the current market conditions in the currency arena have been a little more volatile of late, generally, there are big divides between the movements of forex pairs across the board. Take EUR/GBP for example. This can usually be traded with a typical two- to three-pip spread and is traditionally a much slower mover than other currency pairs, making it an ideal, cost-effective market for intraday swing moves and positions. On the other hand, if we look at GBP/JPY, the spread can be anywhere between seven and nine pips during liquid market hours, and even higher during "off-peak" times! Sure, it moves in huge 250+ pip ranges quite frequently, however, it can chop a novice trader's account to pieces in a very short time as well! A common mistake among many newbie forex traders is to attempt to use the GBP/JPY pair as a scalping tool based on its tendency to move quickly, but they always forget about the spread. Remember that each and every time you enter a buy or sell position on GBP/JPY, it will generally cost you around $70.00 to $90.00 per standard lot. That is a very high commission to pay in today's world for the ability to enter a trade, no matter how tight your stops are.

Below is a snapshot of spreads during the New York forex session, which can give us an idea of what to expect to pay for doing business day to day:
Figure 1

Click to Enlarge

You will notice that the majority of USD majors offer a far more manageable spread of between two and four pips, making these pairs ideal for novice and professional traders alike. I have also highlighted a few of the more exotic cross pairs for your consideration as well: GBP/JPY, GBP/CHF, EUR/NZD, and EUR/SEK. Personally, I like to trade only when the market offers me the lowest risk and highest potential reward scenarios, and especially if I can find opportunities that also have a tight spread. As tempting as some trades may seem on the odd cross pair, I will always consider if the spread I will have to pay to enter the trade is worth the reward I am looking for. This is just another facet of objectively managing my capital and making sure that my trading is being treated like any other responsible business activity. As tempting as it may seem to take a trade in a volatile market with huge 200-pip intraday swings, I firstly understand that when something seems too good to be true, then it often is. Factor in the spread, understand your costs of entry, and know your market before just clicking buttons!

By Sam Evans, instructor, Online Trading Academy
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