Part 3 of a series : Why Professional Traders Trade Forex.
Reason 3 - Low Transaction Costs
Forex has some of the lowest costs of doing business of all tradable markets. We will start today by taking a look at some of the typical costs of trading other markets.
Typical Market Transaction Costs
When calculating the cost of a trade there are a number of different charges that may arise depending on the exact market being traded. Commissions or brokerage fees are the most common and relate to a price that the broker charges the client for having facilitated placing their trade for them in the market place. In the stock, options and futures markets, you will pay a commission or brokerage fee on every single transaction - this is pretty much impossible to avoid. Normally you pay this fee when you open a position and again when you close it so it is the full 'round turn' cost that we need to consider.
Round turn simply means the total commission on the trade from open to close.
Another fee that can arise is exchange fees which are an extra charge that the trading exchange might charge, as compared to the commission charged by the broker. Usually this is collected as part of the commission but be careful as often in futures markets it is quoted separately to make the round turn commission looks cheaper than it really is.
No Commission for Forex Traders
In the forex market things are quite different and traders pay the spread only, there is no commission. In fact, if there is a forex broker charging you commission then it is that broker who should probably be avoided! There are still a few forex brokers clinging to charging commissions and they are asking to lose their business to someone else in my opinion. There are also no exchange fees in forex as there is no physical exchange to charge the trader a fee. The only transaction cost in forex is the spread.
The Cost of the Spread
To compare forex to the stock market, let's say that Telecom NZ is trading at $2.28/$2.29. If we are to buy 10,000 shares at market price right now, we always pay the offer price which is the price on the right. If you, like many people, get confused about which of the two quoted prices you pay, just remember that if you choose to pay the current market price, you always buy at the highest price and sell at the lowest price. This means that if you buy at market you are forced to pay the spread (the alternative would be to place your own bid in the stock market to try and get a lower price which may or may not get filled).
In the Telecom case therefore, you can buy 10,000 shares now at $2.29. Let's assume purely for illustrative purposes that you sell again instantly at the bid price of $2.28. You have now lost 1c on each of your 10,000 shares, totalling a spread cost of $100. On top of this charge you can add a minimum $30 commission which is a low discount brokerage rate for trading yourself online, meaning your trade costs are around $130. The spread could be wider (meaning higher cost) or it could be tighter (meaning lower costs) but there will always be a spread on stocks and there will always be a commission.
In forex, with no commissions, we pay the spread as our total cost. This is why forex traders are always shopping around for the tightest spreads as this is the equivalent of a stock or futures trader shopping around for the lowest commissions. The thing is, the stock and futures traders also pay the spread most of the time if they are buying at the offer and selling at the bid. They just have the disadvantage of more fees on top of the spread. The forex trader pays the spread and the spread alone.
Let's compare the Telecom stock trade example above with a similar value trade in the forex market on NZDUSD. The total trade value for 10,000 shares at $2.29 was just shy of NZD$23,000 worth of stock. We can take a NZD$23,000 position on NZDUSD which gives us the same dollar value for a fair comparison. Let's say the kiwi is trading at 0.7834/0.7837 - a 3 pip spread.
We buy now at the offer price of 0.7837 and, just like we did on Telecom for illustrative purposes only, we immediately sell at the bid price of 0.7834. We have paid our total cost of 3 pips of spread (no commission) which in this case is NZD$2.30 per pip x 3 = $6.90. That's quite some saving versus the equivalent size stock trade for somewhere in the region of $130! Even if you bought Telecom at the bid and paid no spread, the unavoidable $30 commission alone is over 4 times higher than the forex spread cost. And the good news is this... many forex brokers now offer spreads on NZDUSD of less than 2 pips, meaning your costs can be even less than those described conservatively above.
Some people might argue that's not a fair comparison and that a stock is likely to move much more than a currency in percentage terms, meaning that a $23k position on each is not comparing like to like. Regardless, it does not matter since you can still take a significantly larger position size in the forex market than the $23k position discussed, and still pay a significantly lower charge than the comparative stock market fees for smaller trades.
The Cost of Carry
Before anyone thinks I missed the cost of financing charges or carry interest in the forex market, I have not missed it but rather chosen not to list it as a cost since carry costs can be both 'paid to' the trader as well as 'paid by' the trader. This is a whole other topic and one I will write about next week.
Some people like to say that forex is risky for small traders and I discussed last week that while risk exists in every kind of investment, often the most risk lies with the trader themselves. For those that suggest trading stocks as a better alternative, consider the typical person getting started in the markets has $5-10k to trade with and consider the damage of stock trading commissions for this trader. It will eat them alive! I have been there and done that early in my career and learned the hard way that active stock traders have to be extremely good, just to cover their costs alone let alone make a profit.
In trading just like in business, it pays to watch your overheads. Forex has some of the lowest overheads for active traders and this is one of the reasons people choose to trade it.