Tuesday, 25 November 2014

Basic Trading Concepts Defined- Costs of trading


Cost of Trading

Choosing the best commission model for your investment needs is no easy task. There are many costs involved when trading, and understanding trading commissions, as well as other costs, can help you make the best decisions with your account.


What are Trading Costs

When you place a trade, there are several expenses that you face. Some are required, while others are optional. The required costs include the commissions you pay to the broker who places orders for you. Even if you use an online brokerage, you have to go through an accepted organization or individual to place your trade, and that entity receives a commission. Generally, these commissions are low, but remember to ask the broker before you open an account. Optional costs include things that you use to help you make decisions, like additional information services and market analysis. Always ensure that you use a fast Internet connection so that you get your trade in sooner. This is often important when markets are in flux because clicking to order when you see a price does not guarantee that you will get that price. The price that you will get is the one that is in effect when the brokerage receives your instruction and places the order, both of which can involve a slight delay.


Your broker makes money from your trades in one or two ways (or sometimes both):

When you place a trade, there are many expenses that you face. Some are required such as broker commissions, while others are optional such as additional market analysis.

Commission included in the spread

The first way that a broker makes money is the spread. When you inquire about a specific trade, your broker will give you two prices. One of these is the buy price and the other is the sell price. The difference between the bid and the ask price is referred to as the spread. Brokers who offer this type of structure will add their commission to the underlining market price.


Here's an example

You tell your broker that you want to buy EUR/USD, and your current price chart shows 1.1800 (Sell) and 1.1803 (Buy). This means that the broker has received a real price of 1.1797 and 1.1800 and has then added a 3-point commission inside of that spread. When you choose the "buy" button, you move into that position that will be filled or executed at 1.1803. You are paying 3 pips for that spread (the difference between 1.1803 and 1.1800). This spread is one of the costs of placing a trade. You will always start off with a loss when you open that trade, and if you want to make a profit, the price has to change enough to cover the cost of the spread, as well. In simpler terms, if the sell price goes above the price of 1.1803 you will start to make a profit.

Spread costs vary significantly, depending on the financial instrument that you want to trade and the current market conditions. When markets are calm, without much volatility or activity, you are likely to see a 2-pip spread. When volatility goes up, though, the spread may increase to reflect the extra risk.

Some brokers just charge you the spread. Others charge you a commission, as well. This works like the spread in that it applies to each trade that you place. Factor this in to help you make your investment decisions, because it will affect your overall profit margins.

Brokers will offer two prices: the buy and the sell price. A broker will then include a commission inside of the current spread.


Separately charged commission

Commission charges are either fixed or variable.


Fixed Commission

A fixed fee is the same, no matter what the volume and size of the trade may be. Your broker, for example, might charge $0.30 for each per-contract or executed trade.

Let’s see an example:

You buy 10 contracts of EUR/USD with your broker. The broker charges a fee of $0.30 per contract. As you have to open and then close a trading position, the total charge per contract is $0.60.

As you are buying 10 contracts, your total cost for opening and closing this position will be $6.00 (10 x $0.60).


Variable Commissions

It’s common for brokers to charge a variable commission. Generally this refers to a set dollar value per each million. An example might be a fee of $5 per $1,000,000 (notional value) of a currency transaction that is sold or bought. Frequently, the commission goes on a sliding scale in order to encourage bigger trades, but each broker is different. You'll want to research the commission and spread structure with your potential broker before making any trades.


Let’s see an example:

1. You buy 10 EUR/USD contracts with your broker. The current price to buy the EUR/USD is $1,367.

2. The broker charges a fee of 0.030% per one million traded (notional value). The broker charges a fee of $4.10 for 10 contracts. But remember, as you have to open and then close a position the charge would be $8.20.

3. Calculation: (Current price)  X  (Commission percentage)  X  (10 contracts)  X  (2: opening and closing the position)

4. (1367)  X  (0.030%)  X  (10 contracts)  X  (2 positions: open & close) = $8.20

Fixed commissions are charged per contract or lot, while variable commissions are charged based on the investors trading volume.


Overnight Financing Cost

Margin costs accrue when you borrow money from your brokerage to purchase an investment for which you do not have the cash on hand, and then you hold the investment overnight (typically after 22:00 U.K. time). These rates vary between 1.5% and 6%, usually, and are based on the current interbank rate (Libor rate, Tom next rate)

Let’s see an example:

1. The broker charges 2.5% on top of the relevant interbank rate.

2. You buy 100 Apple shares at 110.00.

3. Your trade’s total value or exposure is $11,000.

4. The margin for this product is 5%. So you are borrowing $10,450 (11,000 - 5%) from your broker.

5. With the details above we can now calculate the commission cost for holding a position overnight:

6. 10,450  X  2.5% / 365 days (we divide this by 365 days to give us the daily commission) = $0.73

If you’re using a margin account and hold a position overnight (typically after 22:00 U.K. time), the broker will usually charge a commission fee due to the risk incurred.


Inactivity Charges

An inactivity fee applies if you have not made any exchanges within a set period of time. Periodic minimums refer to a minimum trading-activity amount in which you must engage each month, quarter or year. Again, these rules will vary from one brokerage to the next.


Bottom Line

As you can see, you need to take a careful look at your own possible trading habits before choosing a relationship with a broker, as the fee structures vary widely. If you are planning to keep a trading position open for a number of days, weeks or months, it is best to do so with the lowest possible interest rate.

Entering the financial market is an exciting opportunity for many investors, although the challenges can also be nerve wracking. This article shows you the structuring of some the required costs of doing business as a trader. If you are new to this wing of finance, taking advantage of some of those optional costs could be a good idea, as well. Paying for additional technical analysis, news, charting, or information from your brokerage is one potentially helpful approach, as the more tools you have, the higher your chances of success.



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