From slippage to income tax, here are several hidden costs in forex trading that you should know if you want to give full commitment as a full-time trader.
People join forex trading to get some additional money through profit. They choose a brokerage that might help them to gain profit. However, brokerages or brokers come with some costs that sometimes impact profitability. Therefore, consider the costs of the brokerages, whether they are reasonable or not.
Some brokers' costs that traders should check are:
- Slippage: The difference between the expected price of a trade and the executed price.
- Spread: Difference between the bid and ask prices.
- Commission: Charge a broker applies to compensate for zero or raw spreads, usually counted in lot sizes.
- Funding cost: Refers to deposit fees.
- Swap: The interest traders earn or pay for overnight trades.
- Taxes: Taxes from accumulated profits as regulated by the traders' country laws.
While the information itself is not exactly hidden, not many forex traders realize the abovementioned fees. But how do those costs affect trading?
Slippage refers to the difference between the expected price of a trade and the executed price. It is a part of the ECN/STP environment trading that is usually considered negative. Here is an example of slippage in a demo and a live account:
You open a BUY position for EUR/USD on the demo account that does not offer actual transaction and no subject to slippage. Your transaction is executed with the market price of 1.10543 and is closed at 1.10600 with 1 lot trading volume. The difference between those prices is 57 points, so it will translate into your profit on the demo account.
Now, let's turn to the real account. A real trading account is subject to slippage. Let's say the negative slippage at the open price is 10 points, causing the position to be executed at 1.10553. When the trade is then closed at 1.10600, your profit will only amount to 47 points, 10 points fewer than the position in the demo account.
There is also a positive slippage that possibly significantly affects the profits, especially for the limit orders. A limit order is normally set at a fixed or better price. The fixed price means without slippage, while the better price means positive slippage.
When the limit order is set, it usually leads to a marked-up price at the Liquidity Provider. This enables brokers to eliminate negative slippage while ensuring the possibility of positive slippage.
Traders should consider the absence or presence of positive slippage since it becomes one of the main considerations of a broker's business ethics and credibility.
A fair trading condition is one that gives the probability of positive slippage. If your broker's slippages only result in profit reductions or bigger losses, it can be considered a damaging hidden cost that you must watch carefully.
Spreads refer to the difference between the bid and ask prices of the same security or asset. Spreads among brokerages are not the same. The more attractive brokers, the lower spreads they have.
Besides, they are prone to drastic changes in illiquid times (when the spread widening happens) and during the release of important economic news. A spread is a must-pay fee that is fulfilled automatically in every trade.
Usually, brokers display the real-time spread comparison with or without the commissions on their websites. They know that the official website is an important first impression for upcoming clients. The clients then assume the spreads displayed are the real ones that they will get once they open an account with the broker.
For your information, not all of the details are accurate because it does not show the real trade execution.
The displayed spreads on the broker's website are usually the top-of-the-book spreads. They may only show the best price for about 5 lots of transactions, whereas the spreads for the next lots can be several pips different. Based on the broker's size and the number of active clients, the opportunity of becoming the client included at the top-of-the-book spread is rare. Considering the average price, you will better know how the trade will be filled.
Commission and Profit-Loss (P&L) Conversion
The commission is the charge applied by a broker for making trades on a trader's behalf. The broker also always charges the commission every time a client opens a position. It is deducted from the account balance. If the volume increases, the commission also increases, and vice versa.
Some brokerages choose to offer very tight spreads and charge their clients with commissions. Other brokerages announce on their website that they charge for relatively big spreads with no commissions. If you trade in the first type of broker, pay attention to this.
You should beware of the exchange rate of the commission and P&L conversion to your currency. The conversion should happen with a valid rate as displayed on the trading terminal when the broker charges the commissions.
It is also important to know that the calculation needs to be done immediately at the rollover. It is because the currency rate might differ between the rollover and the time the commission and P&L incurred.
While most people understand that deposit is an obvious trading cost, not many understand that it might come with an extra fee called funding cost. Funding cost means some costs you must pay when you put a deposit in your account. The facility usually charges the cost by enabling the money transfer to your account. Therefore, funding costs can be different based on payment methods.
Usually, the broker gives a free deposit fee for those depositing through a local or partner bank. However, some brokers might charge a small fee for traders who deposit through e-wallet.
While it seems trivial, this could affect the trading cost spent for each trade.
Now imagine if the broker has a minimum deposit of $100, but they also charge traders a $10 fee for each deposit, with no exceptions. That means a trader must prepare $110 in order to trade with $100. If the traders aren't aware of this funding cost, they might be surprised to find that they only have $90 in their account instead of $100.
Swap is the interest traders earn or pay for a trade that keeps their positions open overnight.
Normally, a currency with a high-interest rate is stronger than other currencies with lower interest rates. It means the currency value relies on the interest rate. The rates are also prone to change as central banks sometimes need to lower or increase their interest rates in response to the current economic condition.
The difference between the interest rates of two currencies in a pair is a swap. It can be positive or negative, depending on the currencies involved and the type of position that you open.
In forex trading, the swap rate is only applied for overnight positions. If you don't have a floating position that you keep holding to the next trading day (based on your broker's server time), then you will not be charged the swap rate.
Interestingly, traders are often misled by the opinion that positive swaps are worth the effort of analyzing and turning into a trading income.
It may be true for some experienced traders who apply the carry trading strategy, but it can be a complicated matter for beginners who don't understand the intricacies of forex fundamental outlook and the big picture analysis.
For most traders, understanding the swap rate can be limited to an unexpected trading cost incurred by the broker. Hence, you should monitor the swap rates of your broker, especially if you tend to have overnight positions.
The false opinion among traders is that the biggest drawback of forex trading is due to errors in their trading strategy. While the notion is not all mistaken, it leaves the hidden factor not all traders know: the tax that can reduce the profit earned from trading.
In some countries, the taxes should be paid when the profit is accumulated and informed at the year's end. This is particularly relevant for traders in a country recognizing forex trading profit as a taxable income.
If you live in such a country and plan to be a long-term trader, this hidden cost should be included when weighing the pros and cons of being a full-time trader.
Your broker does not provide tax information as it is a policy implemented by the government. So, you must learn the amount and the payment mechanism of the tax charged to your trading income.
Hidden Costs in Forex Trading Could Interfere Your Income
It is normal to try to make a profit for each trade. You can optimize your trading strategy, manage your capital, and train your trading psychology as best as possible. Yet, you also should be aware of the hidden costs above as they may reduce your profit or even add to your loss if not regarded carefully. Be a smart trader who is always considerate of all commissions and costs because, in the end, the net amount is the most important one.
Not only the aforementioned hidden costs, but another external factor that may influence your trading performance could also come from the inspiration from other successful traders. Find out and explore all about it in Trading Success Story.