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The Importance (and Calculation) of Transaction Costs

The Importance (and Calculation) of Transaction Costs

2014-10-02 19:06:00
James Stanley, Currency Strategist
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Summary:

FXCM is changing the spread and commission structure offered to clients; and this article is designed to walk you through those changes. For more details, please read the sections below this summary.

The quick takeaway is that rather than including commissions (markup) in the spread; FXCM is offering clients ‘raw’ spreads. Raw spreads include no markup, and this is like other markets such as stocks and futures in the fact that the spread is completely a function of liquidity and prices offered via liquidity providers.

FXCM's commission is now separately accounted for as a 'commission' based on the pair and size traded.

This is also coupled with an overall reduction in trading costs that can greatly benefit customers. We explain further in the following sections.

To calculate spreads using the new commission model with comparison to the old model:

The Importance (and Calculation) of Transaction Costs

The What:

Trading is much like any other business that one might embark upon. Expenses are incurred in the search of revenues; and hopefully those revenues are greater than expenses incurred so that the remainder can go into the ‘Net Profit’ category. This net profit is money in the pocket… this is income, and this is the reason that people trade or go into business… the goal of making money.

A key part of this equation is cost. Because it doesn’t matter how much you make in revenues, if your costs are greater than the amount brought in; well, you’re losing money. It’s really that black and white, and it’s really that simple.

FXCM is embarking on a massive change with the goal of helping customers in that search for profitability. FXCM is initiating a change to reduce transaction costs while also making these costs significantly more apparent. While this may sound altruistic, this is a business move and we explain the ‘why’ later in the article. For now, we want to show off some of the new spreads along with the process to calculate transaction costs.

If you’d like to see the new spreads + commission pricing model, you can open a demo account with the new pricing model from the link below:

Please click HERE to open a new demo account with updated pricing model

The How:

Previously, FXCM rolled all transaction costs into the spread with the goal of making this easier for clients to manage. This was a standard operating procedure in retail FX, but was quite a bit different than other markets such as stocks, futures, or options.

Under the new pricing structure – there are two separate costs that are incurred when trading a position and this is very similar to those previously mentioned markets like stocks and options.

The first is the spread… and the big difference is the size of the spreads. The second is the commission.

The Spread

Previously, the spread on FXCM platforms included the commission or markup charged by FXCM. This is changing in the fact that FXCM’s commission is going to be split away from the spread.

The spread is now a pure function of liquidity and prices at which liquidity providers are willing to bid or offer in that particular market. This is similar to the manner in which equity, commodity, and option markets trade. FXCM will receive no compensation from the spread under the new commission model.

Please note that spreads will still be variable based on market activity. Spreads can widen out ahead of news announcements because, like you, these liquidity providers don’t want to take a loss on a major news announcements. To compensate for the increased risk of trading/taking positions during news, those spreads can widen out. This is going to be true anytime you’re receiving access to legitimate market liquidity. To fix a spread is to make a market; and that’s indicative of a dealing desk that can take the other side of their customer’s trade.

The reduction in spreads is remarkable. Previously the average spread on EURUSD was 2.5 pips; and once again – this included FXCM’s commission.

The average spread on EURUSD under the new model is .2 pips. That’s a ‘point-two’ pips; not a full two pips.

The average spread on AUDUSD under the new model is .4 pips. Cable (GBP/USD) is .6, and USDJPY is .3. You can see the full list of average spreads under the new model at the link below:

Please click HERE to see FXCM Pricing

The Commission

The biggest change is going to be the inclusion of a separated commission that was previously included in the spread.

There are two different commission structures based on the pair being traded. Very liquid pairs such as EURUSD, GBPUSD, USDJPY, USDCHF, AUDUSD, EURJPY, and GBPJPY will be four cents per 1k, per side.

All other pairs will be under ‘commission schedule 2,’ which will be six cents per 1k, per side.

So if a trader places a 1k trade in EURUSD, the commission to enter the position would be four cents. The commission to exit the trade would also be four cents. The ‘round-trip’ cost of the transaction would be an eight cent commission for a 1k lot.

If the trade size was larger, let’s say 100k – we can simply multiply the four cents per 1k by 100; and the commission would be four dollars to enter, and four dollars to exit. The ‘round-trip’ commission of EURUSD on a 100k trade size would be eight dollars.

For less liquid pairs, let’s say AUDCHF, the commission is six cents per 1k, per side. So a 1k trade in AUDCHF would cost six cents to enter, six cents to exit for a total commission of twelve cents.

A larger trade size, such as 100k in AUDCHF would entail a commission of six dollars to enter and six dollars to exit (.06 * 100 = 6.0). So, the ‘round-trip’ commission on a 100k position in AUDCHF would carry a commission of $12.00.

Putting it all together

Spreads and commissions are being reduced with the new pricing model from FXCM.

The average spread in EURUSD was previously 2.5 pips on FXCM platforms. Now the average spread is .2 pips under the new model. The new model also introduces a commission on each trade of four cents per 1k on the most liquid pairs such as EURUSD.

A 1k trade in EURUSD previously was 25 cents (2.5 pip average spread * 10 cents per pip); and under the new model that cost would be 10 cents ((.2 pip average spread * 10 cents per pip) + (four cents per side per 1k * 2 (to enter and exit)).

A 100k trade in EURUSD would previously have entailed a cost of $25 (2.5 pip average spread * 10 dollars per pip = $25). Under the new model, the total cost for a 100k EURUSD position would be $10 ((.2 pip average spread * $10 per pip = $2) + (four cents per 1k per side * 100 = $4 * 2 (to enter and exit))).

The image below walks through the new pricing model using various trade sizes in EURUSD:

The Importance (and Calculation) of Transaction Costs

The Why

Point blank: FXCM wants their traders and customers to win. FXCM was a pioneer with No Dealing Desk Execution; which aligns the interests of the broker with those of their clients. With NDD execution, FXCM passes all orders received directly to the liquidity provider offering that price. This means FXCM never trades against their clients, and only receives income when traders place trades. In this relationship, the interests of the broker and client are aligned. This differs mightily from the dealing desk scenario in which the broker can take the other side of client trades… meaning if the client wins, the dealing desk could lose. This inherent conflict-of-interest was a necessity at the beginning of the retail FX market, as banks had little interest in taking a 100k (standard lot) position, much less a mini (10k) or micro (1k) lot; but today, this model is antiquated and quite frankly, potentially dangerous to clients and brokers.

The standard for retail forex execution is now No Dealing Desk.

With NDD execution, the broker does not trade against their own clients… all orders that come from FXCM customers go directly through FXCM’s platform to the liquidity provider offering that price. FXCM acts in the true essence of a broker – as a conduit between buyers and sellers, making a small amount on each transaction for the service provided. This was game-changing at a time when the standard execution model in FX was a dealing desk arrangement; whereby brokers could take the other side of a client’s trade… This is an inherent conflict-of-interest… If a broker takes the other side of a client’s trade, and the client wins – that means that the broker may lose from the simple act of their own client winning. This has led to practices such as re-quotes and/or shading.

This is precisely why DailyFX/FXCM makes a concerted effort in Education and Analysis; to try to help their clients and traders as much as possible in that quest for profitability. The new pricing model along with reduced commissions is another aim to help those traders even more.

--- Written by James Stanley

Before employing any of the mentioned methods, traders should first test on a demo account. The demo account is free; features live prices, and can be a phenomenal testing ground for new strategies and methods. Click here to sign up for a free demo account through FXCM.

James is available on Twitter @JStanleyFX

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