There are a number of things that make a person a better trader, and several of those things have absolutely nothing to do with a person's ability to trade. Over the years, I have seen a number of wildly different scenarios – from money mangers charging huge on the front and / or backend to retail traders going with a broker that charges them extraordinarily high costs. Some people realize the high impact transaction costs have on them over the long run while others tend to sacrifice this knowledge for other things.
In the Professional Environment
Transaction costs are such a huge deal that they are commonly written about in college or university portfolio management classes (I know they were with mine) and analyzed in the corporate world with companies such as the Investment Technology Group specializing in detailed transaction cost analysis. There is no other way of describing this: transaction costs eat away at your P&L. They will suck you dry like any other fees.
Below is a graph of simple, backtested hypothetical results of the same trading system. The top image shows the graph in a simulated environment, while the other shows actual results. Even from a rough example such as this it is easy to understand how drastically fees could affect your P&L.
Source: Aswath Damodaran
New Regulations Regarding FCM transparency
New regulations imposed by the NFA and CFTC last year have forced brokers to show their curve of profitable vs. unprofitable accounts. From a retail perspective, we can start to see some things unfold which has us curiously wondering about the direct impact what these brokers are charging for spreads has to do with their clients making money.
The one that has been consistently topping this list is, no surprise, Oanda, who from our knowledge has some of the cheapest commissions offered to the retail world. They might not have the cheapest spread, but they are also not charging on the backend for lot size, which many ECN brokers have taken a fancy to do doing in recent years.
2010 Q4 Results
This black-and-white example could indeed be attributed to other things, but as we have always known, Oanda tends to carry and open book in terms of what it is that they do and how they operate. It is one of their best selling points (clearly from their perspective) just casually looking through their website.
Other brokers that fall to the bottom of this list, we won't comment on, but you can do the math. They start to get mixed around the midway point but that, of course could be simply contributed to luck of the pot in terms of who they get for clients.
Here's how badly a steep charge could affect you:
Let's assume you only trade with 1 standard lot, or $10 per pip where USD is the secondary currency.
– Broker A charges 2.5 pips on EUR/USD, or $25 per trade
– Broker B charges 1.5 pips on EUR/USD, or $15 per trade
Now let's assume you make 15 trades per week:
– At Broker A that would be a total of $375
– At Broker B that would be a total of $225
The difference between the two is of course, $150 in additional commissions given to the broker charging higher costs per week. Assuming you maintained consistency throughout the year and traded 15 times every week, just by having a more expensive broker you would be losing $7,800 in pure cash. And where is that money going? Someone else's retirement account…not yours.
Considering the fact that many traders tend to overleverage themselves in this industry it is no wonder why so many get burnt when you take a factor as heavy as this into play. And considering the paperwork and hassle that goes into opening a trading account it is also no wonder why many people never make the switch once they realize that something is terribly wrong.
WHY do people opt for brokers that generally offer higher spreads in the first place?
1. Bells and whistles. People don't want to pay for charting software or some other service so they go with a broker that will offer it for “free”. Let's assume in the example above your charting service was $100 per month, or $1,200 per year. That is a heck of a lot better than paying $7,800 to your broker on costs. It is a matter of perspective.
2. Inexperience. You haven't been around too long so you pop for the broker that just advertises, or gets in your face the most. Nice website….must be good….ehe?
A term very well known to your market making broker, but perhaps not you is “mark up”. Your broker essentially buys at a specified price from a dealer, and gives you another. The difference between these two numbers in the markup. Depending on liquidity and any other general rules your broker has chosen for themselves, this is yet another factor that could affect your execution.
One thing I would always recommend is to simply compare the price feeds from broker to broker, side by side, and see that you are truly getting what you deserve. If there is a way to increase any form of unfair advantage, this is certainly one of them, but then again is it much different than any other business that buys wholesale and sells retail? Your emotions might take over the answer to that question.
There are other factors, of course, that come into play and a while ago we outlined many of them in our 12 Considerations for Selecting an FX Broker. Just be aware that execution is also a very relevant part of this list, as is a watchful eye through government regulation, etc. Spreads certainty aren't the end of the story when it comes to picking a broker that is right for you.
As common sense as much of this might be, it is a simple wake-up call in terms of your costs. As a call to action: if you are paying high fees and you know it, we urge you to do something about it…..fast. You can't go wrong with exercising some good old common sense.