In our last lesson we continued our series on choosing a forex broker with a look at two of the most important factors to consider, the regulation and financial stability of your broker. In today's lesson we are going to continue this discussion with a look at another important factor to consider, transaction costs.
As when trading any market, the transaction costs one pays can have a significant affect on returns, especially for the active trader. Unlike other markets however, where transaction costs outside of commissions are fairly standard, because the forex market is over the counter, transaction costs can very widely from broker to broker. In order to follow this lesson everyone must first understand what an over the counter market, spreads, and rollover are, so if you have not done so already I encourage you to pause this video and review the lessons on these subjects in module's 1 and 2 of this course.
There are generally four things that a trader should consider when reviewing the transaction costs of a broker he or she is considering trading with which are:
1. Commissions if any that are charged by the broker.
2. The Spread for the currency pairs that they wish to trade.
3. The rollover rates for the currency pairs they wish to trade, assuming they will be holding positions past the rollover cutoff.
4. The quality of the execution traders receive on their live trades.
The large majority of brokers do not charge a commission, however when analyzing those that do, most traders will add the spread for the currency pair that they are trading to the commission, in order to calculate the total transaction cost for the trade. The important thing to keep in mind here, is that while commissions are normally fixed, the pip value for each currency pair varies depending on current market rates, and whether or not the US Dollar is the second currency in the pair or not. As an example, the current pip value when trading on a standard account for USD/JPY is $9.25, and the current spread with the broker I am looking at is 2.5 pips. So if this broker were to charge a $10 commission on top of this, then my total transaction costs would be 9.25*2.5+10 or $33.13.
Lastly in regards to commissions, when you inquire about the commission level, you want to know whether the commission rate a broker is quoting is per side or round trip. If the commission in the example I just gave was per side, then this would mean there is a $10 commission to open the trade, and a $10 commission to close the trade, bringing the total commission for the trade to $20. If it is round trip, then this means the commission to open and close the trade is $10.
The second factor to consider when evaluating transaction costs, is what the spread is for the currency pairs that you will be trading. You can calculate the spread in dollars here again, by taking the value of a 1 pip move in the currency that you are analyzing, and then multiplying it by the spread. It is important to keep in mind here however, that the spread with many brokers will fluctuate throughout the day based on the liquidity of the currency pair that you are trading, and the volatility in the market at the time. With this in mind, it is important to consider the spreads during the time frames which you will be trading. While many traders like to inquire with a trader who is already trading live with the firm they are considering on this point, generally I have found that the demo platforms are a fairly accurate representation of the type of spreads you will see on a live account.
The third fact that it is important to consider when evaluating transaction costs, is the rollover rates that a firm deducts from your account when you are long the currency with the lower interest rate, and the rate that they pay into your account when you are long the currency bearing the higher interest rate. While this is not very important for active traders who rarely hold positions overnight, this is especially important for traders executing longer term strategies, where the rollover rate can have a significant affect on the return of their strategy.
The last factor that it is important to consider when looking at transaction costs, is the execution that you receive on live trades. Unfortunately demo accounts are not normally an accurate representation of live execution, so there is no way to know this for sure, without opening an account and executing some trades. From my experience here as well, the message boards (for the reasons I covered in our first video in this series) are not a good representation of reality in this regard. Once you have a live account however, in normal market conditions you should be executed without slippage and the prices that you are being quoted should be in line with what other market makers are quoting (which you can see by pulling up their demo accounts). If you are being consistently slipped on trades and/or the rates that you are being quoted are consistently off market, then you know there is a problem and can address it accordingly.
That's our lesson for today. In our next lesson we will continue our series on choosing a forex broker with a look at some of the main features of the different trading platforms out there as well as how to evaluate the customer service of your broker.
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Risk Disclosure: Trading forex on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading, and seek advice from an independent financial advisor if you have any doubts.