Guest post by Currensee.
There’s a lot of misinformation out there when it comes to retail foreign exchange trading. I was recently pointed to a blogger who was addressing the latest CFTC rules change proposal (the one suggesting 10:1 leverage caps), and was appalled by the blatant factual errors in his post.
Spreads and Commissions
Here’s the first statement this individual made which I think needs addressing because it includes a real source of confusion, especially for those new to forex trading.
“If you short the Euro/USD cross, for example, and expect a 100 pip (one cent) move on your trade, you might pay three pips of spread to enter and another three to exit, for a total “vig” of six pips. That’s a 6% commission!”
First of all, you don’t pay two spreads. In fact, you don’t really “pay” a spread at all, though certainly it is a cost. The only time the spread impacts you is when you first open a trade. Let’s say the market for EUR/USD is at 1.4500-1.4503. If you go long, you will enter at 1.4503 ask/offer price. Now in order to exit your long you would sell at the bid price of 1.4500. As a result, you have a 3 pip loss from the outset. That’s the only time the spread comes out. If the market moves to 1.4600-1.4603 – the 100 pip gain noted in the quote – you would exit at 1.4600 for a net gain of 97 pips, not 94 as suggested.
Second of all, the 6% calculation is based on being leveraged at 100:1. I’ve already shown that the spread loss is not 6 pips, but rather only 3, so that cuts the cost to 3% on a fully leveraged position. Most traders, however, don’t go anywhere near 100:1 leverage. Experienced folks often limit themselves to 10:1-20:1. At 20:1 the spread cost is 0.6%, while at 10:1 it’s only 0.3%.
But wait! The 6% calculation is also based on erroneous figures. It assumes that a full contract is worth $100,000 and a pip is $10. The value of a full EUR/USD lot priced at 1.4500 is $145,000, for which $1450 would have to be posted as margin at 100:1 leverage (1% margin requirement). A 3 pip spread value of $30 on that full contract would thus only be about 2% of the post margin. Going with the lower 10:1-20:1 leverage noted above, the more realistic cost for the trader is 0.2%-0.4%.
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Thirdly, the blogger compared forex to e-mini S&P 500 futures by suggesting that in the futures the commission is only $6 for a full round turn (in and out), but he fails to account for the fact that futures have spreads too. I see this happening all the time – people out of ignorance claiming that other markets don’t have spreads. Every market has a bid/offer spread. The usual spread in the e-mini S&Ps is a quarter point, or $12.50 (a point being $50). When you add in the $6 commission to the spread cost you get $18.50. That’s about 0.4% of the blogger’s $4050 noted initial margin requirement. Looks comparable to me.
The other issue that was brought up was the fact that in forex trading there is carry.
“…unlike a stock, option or futures trade where one pays to enter and again to exit (but not to hold) a FX position is inherently a short-term trade, as you will be charged simply for the privilege of holding your position open over a period of time.”
Granted, there is no carrying cost in stock trading, unless you’re trading on margin, in which case you have margin interest to pay. There is carry in each of the other markets, though.
In options time decay is a cost of carry for those long the option, but a benefit for those who are short. In futures there is a spread between the contract price and the underlying spot market price, which moves to zero as the contract nears delivery. In some cases the spread is positive, while in others it’s negative. Obviously, the forex market has daily roll-over/carry which can either go for or against the trader depending on which way the interest rate spread is going.
In other words, unless you’re a short-term trader, there is a carry involved in all the markets except stocks. It may work to your advantage or it may work to your disadvantage. To claim otherwise is to be misinformed.
The bottom line is that retail forex trading is pretty comparable in terms of its costs to other markets available to individual traders. If you have any doubts, run the numbers based on your own trading. Keep in mind too that it behooves forex brokers to be price competitive when compared to futures. If not, they stand to lose especially their bigger customers (and thus their bigger volume) to the futures market.