Transaction costs in Forex, is the "elephant in the room” when evaluating the performance of a trading account. While all traders are aware of it, many and money managers still manage to underestimate how significant of an impact transactions costs can have on their overall profitability. This blog post will explain how forex traders can better understand that impact and how they can identify which business terms would suit their trading style the best.
We will begin by defining what transaction cost is and clarify the different ways they can be incurred by traders.
According to Investopedia, transaction cost is any expenses incurred when buying or selling securities. Although forex is technically a commodity, this broad definition still applies. To go a step further, we can break transactions costs down into two categories, Considered Cost and Unexpected Cost.
Considered Cost refers to any transaction costs that are disclosed by banks and brokers that provide liquidity services. These costs are typically the bid/ask spread and commissions, although monthly minimum volumes fees are becomming more common in today's business climate of tighter credit. It is relatively simple to get an accurate estimate of how these costs may influence your profitability - simply take the total volume traded in any particular month and multiply it by the per-lot transaction cost.
For example, if you are trading on a 0.4 pip EURUSD spread with a $1 per standard lot commission, your average transaction cost per million USD traded is roughly $3 per standard lot (assuming the spread remains constant at 0.4 pips). Here is how that breaks down:
The commission is charged for each executed transaction - both at the open and the close of the position - and so it is $1 per standard lot executed. The cost of the bid/ask EURUSD spread is $4 per standard lot. If you execute an order to buy EURUSD to open a new position, you pay $1 per standard lot in commission and $2 per standard lot in spread - this is the total cost of the spread at the time of execution (0.4 pips) divided by 2. When you close that position, you pay $1 per standard lot in commission and $2 per standard lot in spread. Therefore, the average transaction cost for each million USD executed is $3 per standard lot.
Keep in mind that if the spread is variable, you would have to calculate the spread costs as 1/2 the spread at the time of execution at the open of the position, and 1/2 the spread at the time of execution at the close of the position.
However, Unexpected Cost such as slippage can be tricky to calculate due to a constantly changing market environment and volatility. In determining the magnitude of slippage effect one must consider several factors, including the overall directional bias of the strategy ( pro-trend / contra-trend ), trading hours ( US / Asia / Europe), and trading frequency ( scalping / swing trading ).
Slippage is the difference between the requested price of an order and the executed price. It usually occurs during periods of high market volatility volatility, which is often the case following fundamental news announcements, where many buyers and sellers withdraw from the market due to the higher level of perceived risk of trading during those times. In these trading conditions, most forex brokers will execute the trade at the next best price available, resulting in negative slippage for a trader.
According to Rishi N Rang and his book Inside the Black Box, slippage accounts for more than half of all transaction cost combined. If you have already calculated your monthly Considered Cost, now double it - what percentage of your overall monthly profit and loss would that be?
Unfortunately, it is difficult to account for the impact of slippage in a demo account, because demo accounts simulate trading with an unlimited amount of liquidity at each price. As a result, a strategy executed in demo account will rade with flawless execution and it may show far better results than would be the case trading under live conditions.
Furthermore, not all forex brokers are created equal when it comes to slippage. Brokers with low access to liquidity will generally be unable to execute their client trades during volatile markets at the clients' requested price. The better access your broker has to the liquidity marketplace, the faster your trade will be executed and the closer it will be to your requested price. Therefore, it’s recommended to ask your broker to explain how their access to liquidity might change during news events and what impact you can expect on your execution as a result.