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.
Lets take a practical example to make it clear how trading costs can effect your trading. Bid/offer spreads are usually overlooked by retail traders as the price they have to pay for trading. So lets calculate what your cost of trading can be annually.
Suppose, you are day trading the currency markets, 5 times every day. Take away the weekends, when you cant trade, there are 250 trading days for you.
As a day trader, you will open and close your position before the end of each trading day. That means each position is traded 2 times by you.
Suppose; your start with an account size of $50,000. You are using a leverage of 4 only, you are cautious. So this $50,000 deposit will control (50,000) (4) = $200,000 for you.
Annual Turnover = (5) (250) (2) (200,000) = $500 Million. You can see the annual turnover of your trading is huge! Now lets calculate how much your broker will make and what your trading cost is based on your spread cost. Spread Cost= (Annual Turnover) (spread)/2.
Suppose the spread offered by the broker is 3 pips. 3 Pips Spread Cost= (500M) (0.0003)/2= $75,000.
Suppose, the spread offered by the broker is only 2 pips. 2 Pip Spread Cost= (500M) (0.0002)/2= $50,000.
The cost of trading with a 3 pips spread versus a 2 pips is $25,000. This is 50% of your account equity. You can see yourself that a 1 pip difference can result in $25,000 more of trading costs.
You will need to make a profit of $75,000 simply to break even with a 3 pips spread. Trading costs are one of the primary reasons most active traders fail in the long run.