What Are The Costs Associated While Trading The Forex Market?

trading

As is with any other financial market, trading in the forex market has its set of costs. Primarily, most of these are direct costs that go towards brokers’ revenue while others are incidental costs. Since the cost of trading is regarded as an expense to a trader, it can significantly impact a forex trader’s total profit.

A forex trader can incur charges such as withdrawal fees and inactivity fees when your trading account remans dormant for a specific period. However, in this article, we will cover the most common types of costs incurred when actively trading in the forex market.

Forex Spreads

In forex trading, the spread is one of the most common trading costs. It is the difference between the ‘bid’ and ‘ask’ price. 

There are two main types of spread – fixed and floating spreads. 

Fixed spreads: are set by the forex broker, and they do not change no matter the market volatility or time. For example, if your forex broker offers a fixed spread of 3 pips, it will remain so throughout the trading day. The spread can, however, be changed in case of extremely low liquidity or high volatility; in which case, your forex broker is obligated to communicate the changes beforehand.

Floating spreads: also known as variable spreads, continually change as the values of ‘bid’ and ‘ask’ change. They fluctuate depending on trading volume and market volatility.

When a forex trader sells a currency pair in a short trade, the broker buys the pair at ‘bid’ price indicated on the platform. The ‘ask’ price is the price at which your forex broker will sell a currency pair to you when you go long. You can say that the ‘bid’ price is the highest possible price at which your broker can buy a currency pair from you when you go short; while the ‘ask’ price is the lowest possible price at which the broker can sell a currency pair to you when you go long. Forex brokers are obligated to inform you of the type of spreads they offer for every asset. Here’s an example for Platinum trading.

Typically, the ‘ask’ price is higher than the ‘bid’ price.

Therefore, Forex spread = ‘Ask’ price – ‘bid’ price

The spread is the primary way in which forex brokers earn their revenue. Note that the spread is presented in terms of pips. Here’s how it works.

Let’s say the price of the EUR/USD pair is 1.1830. In this case, the broker will indicate the ‘bid’ price at 1.1830 and the ‘ask’ price at, say, 1.1835. therefore, if you go long on the EUR/USD pair, your position will be executed at 1.1835. In this case, the spread is;

‘ask’ – ‘bid’ = 1.1835 – 1.1830 = 0.0005 = 5 pips

Hence, going long on EUR/USD will cost you five pips.

In another scenario, say you want to short the EUR/USD pair. In this scenario, your order will be executed at the ‘bid’ price of 1.1830. Remember that exiting a short trade implies buying back the currency pair you sold. Hence, buying back the pair from the broker means that you have to buy it at the ‘ask’ price displayed at the time when you close the short trade. For example, if you intend to close your short trade at 1.1820, your order will be executed at 1.1825, meaning that you still pay a spread of 5 pips.

Suppose your position was one standard lot, the value of 1 pip is $10. That means your broker has earned $50 from your single trade. This $50 is a cost to you.

Brokerage Commissions

This is the amount that your forex broker charges for every position you open. Usually, commissions are charged on forex accounts that have 0 spreads.

ECN type accounts typically attract the trade commissions since they are offered raw spreads from the no-dealing desk execution. Therefore, the commission is the brokers’ source of revenue in the absence of spreads.

The commission charged varied depending on the forex broker. Some brokers charge a fixed fee which is a constant amount charged regardless of the size of the trade. For example, a forex broker can set a fixed fee of $5, whether you trade one standard lot or a micro lot. 

Others charge a relative commission which is dependent on the size of your position. For example, it can be calculated as a fixed amount per lot, such as $2 for every one standard lot. Hence, the higher your trading volume, the higher the commission you will pay.

Forex Swap Costs (Rollover costs)

A swap cost is incurred when you keep a position open overnight. These costs originate from the interest rate differential between the currency pairs, i.e., the difference in the interest rate of the base currency and the quote currency. Transparent forex brokers show how the rollover costs are calculated for when a trader is long or short a particular currency pair. Here an example with SDS trading

Note that the swap costs are deducted from your trading account when the interest rate differential is negative and debited to your account when the interest rate differential is positive. Therefore, it is only a cost when the interest rate differential is negative. 

Say, you have shorted USD/JPY and keep the position overnight, it means that you have sold the USD and bought the JPY. If the interest rate in the US is 0.25% and that in Japan is -0.1%, the interest rate differential is;

-0.1 – 0.25 = -0.35%

The swap cost for when you short the USD/JPY will be 0.35% of your total position. If you had gone long on the pair, you would have earned 0.35% instead.

Leverage Costs (Overnight Financing Costs)

In forex trading, the overnight financing costs is the fee your broker charges you for keeping a position overnight using leverage. It is defined as the interest rate you are charged for trading overnight with the money borrowed in terms of leverage. 

Usually, the leverage costs are calculated for the total size of your trade using the LIBOR. For long positions, 2.5% of the total position is added to the LIBOR while 2.5% is subtracted for short positions. Here are the formulas.

For long positions: = Value of the position * (LIBOR+2.5%)365

For short positions: = Value of the position * (LIBOR- 2.5%)365

Conclusion

Whether you are trading the forex market or futures like US30 or the US500, always mind and familiarise yourself with the trading costs involved. They significantly impact your returns.