Why paying close attention to FX trading costs is so important

I don’t know if there are still brokers out there advertising that there are no trading costs in trading Forex. But you all do know better by now. If there are no commissions, they’ll simply mark up the spread to get their share, or worse (see latest FXCM scandal) in some way profit from your positions. That’s why I always prefer to pay commissions, this way there’s at least a chance you’re actually trading and your broker isn’t just on the other side of your „trades“. Also paying commissions results in smaller spreads which will save you more money in the long run than the commission you’ll pay.

Let’s have a look at the major trading costs in Forex. First of all the BID/ASK spread you almost always have to pay (unless it’s 0 which can happen, and sometimes you’ll even get filled at a better price than expected), then volume-based commissions you pay to your broker for executing your trade and if you keep your trade overnight you got to pay some overnight commissions/swaps. Depending on what kind of orders you are using to enter/exit trades, you’ll also have to deal with slippage to some extent.

As trading costs are a reality, it’s important to be aware of them. If you think you can ignore them, maybe because you believe your trading strategy is so good that a couple of pips don’t matter to you then you should think again. There’s a reason why so many professionals are literally obsessed in trying to reduce trading costs all the time. Over hundreds of trades, trading costs will make a huge difference and many strategies that look very profitable without trading costs will look much worse once reality is factored in.

Now each currency pair has slightly different trading costs and it’s important to keep track of these. To keep things simple, I’ll focus just on the BID/ASK spread for now. But you definitely should also pay close attention to the overnight swaps, especially if you’re trading longer term positions and to trading commissions and slippage if you’re day trading.

A day trading strategy might work nicely in EUR/USD for example when your average spread during liquid market hours usually is about 0.25 pips and the average daily trading range (high-low) is about 80 pips. That gives you a daily range (80) to spread (0.25) ratio of 320 (80/0.25 = 320). If either volatility or liquidity dries up in a market, this ratio will drop too. The higher the ratio, the better and for every strategy, there is a point where it will stop being profitable should the ratio drop below. That’s why this is an important ratio you should always keep track of.

Now let’s compare that daily range to spread ratio to EUR/CHF where your average spread during liquid market hours is about 0.5 pips and the daily range is about 30 pips. That’s a ratio of just 60, meaning trading in EUR/USD is about 5 times „cheaper“ in our example. Due to the lower volatility, you’ll also need to trade more contracts than in EUR/USD to get the same bang for the buck which means you’ll also have to pay more commissions. Will your day trading strategy still work in EUR/CHF despite the higher trading costs? That, of course, depends on the strategy but you better do the math and see if it’s still worth trading it in that market after trading costs.

The higher your trade frequency, the more important trading costs are and the fewer markets will your strategy be profitable in. The reason for this is the ratio between the average trade result and the BID/ASK spread + commissions. If on average you make 3 pips per trade, an average spreads of 0.5 pips is much more of an issue than if you’re trading on a longer timeframe and make 30 pips on average.

That’s why it’s so easy to come up with a strategy that trades on a 5-minute chart and looks like it will make you rich in no time until you add trading costs. Trading costs will kill you here unless you’re very efficient in your trade execution (which most retail traders simply cannot afford).

Whenever I develop a new trading system, I run different kinds of simulations to get a good idea of how sensitive the system is to trading costs. This way I get a pretty good idea if it’s actually worth trading the system in the real world. Once I start to actually trade a system, I keep close track of its trading costs. Then I compare the simulated trading costs (what I expect) vs. real trading costs (what I get in real trading). This way I’ll find out rather quickly if I underestimated trading costs or maybe have been too pessimistic and overestimated them. During the last 6 months, for example, I got about 25% better execution on average than my simulated results for AlgoStrats:FX. That’s fine for me as it’s a close enough estimation for my trading style and I’m rather slightly too pessimistic about trading costs than the other way around.

There’s a lot more to say about this topic, but for now, I’d like to wrap it up with my advice that you better pay close attention to trading costs.

Happy Trading!

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