When you start currency trading, you are told by every forex broker that there are no commissions involved in forex trading. New traders take their brokers words as true and most think that the cost of trading is minimal.
Forex brokers are also called FCMs (Futures Commission Merchants) sometimes. They make profits through the bid/offer spread they charge their clients for each currency pair. This bid/offer spread is your trading cost and profit for your broker.
Let's take a practical example. Bid/ask spreads are usually overlooked by the individual traders as the price they have to pay for trading. So let's calculate what your cost of trading can be in a year.
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Suppose, you are day trading the currency markets, 5 times every day. Take away the weekends, when you can't trade, there are 250 trading days for you.
As a day trader, you open and close your position before the end of the day. That means each position is traded 2 times.
Suppose; your start with a deposit of $50,000. You use a leverage of 4 only, you are being cautious. So this $50,000 deposit will control (50,000) (4) = $200,000.
Annual Turnover = (5) (250) (2) (200,000) = $500 Million. You can see the annual turnover of your trading is huge! Now let's calculate how much your broker will make and what your trading cost is based on your spread cost. Spread Cost= (Annual Turnover) (Spread)/2.
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Suppose the spread offered by the broker is 3 pips. 3 Pips Spread Cost= (500M) (0.0003)/2= $75,000.
Suppose the bid/offer spread charged by the broker is only 2 pips. 2 Pips Spread Cost= (500M) (0.0002)/2= $50,000.
You can see yourself, the cost of trading with a 3 pips spread versus a 2 pips is $25,000. This is 50% of your account equity. You see, a 1 pip difference can result in $25,000 more as trading cost for you annually.
You will need to make a profit of $75,000 in a year simply to break even with a 3 pips spread. Trading costs are one of the most important reasons most active traders fail in the long run.
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