Where Is The Commission In Forex Trading?

An important aspect of trading in any type of asset, including currencies, is how much the purchase and sale of the asset will cost.

One significant cost in currency trading comes from commissions on trades. Thus, it is of interest to traders to analyse and measure the types and size of commissions to help determine their costs and potential profits on each trade.

Traders who have experience with other markets such as equities, futures or options will be familiar with commissions. They are frequently charged by brokers in those markets at a flat rate per trade regardless of the volume of the asset that changes hands. Depending on the broker or dealer they use, currency traders will encounter several types of commissions, including fixed commissions, variable commissions and per-trade percentage-based commissions.^[1]

Spread: The Basic Cost Of A Trade

Generally, commissions in forex trading are paid in relation to what brokers and dealers call "the spread." Currencies are traded in pairs, and currencies are typically offered on trading platforms at an "ask" price and at a "bid" price. This means that the broker or dealer will sell a currency to a trader at one price (the ask price), and buy the same currency from the trader at a different, and normally lower, price (the bid price). The difference between these two prices is known as the spread.

Fixed commissions are commissions paid on a fixed spread of generally two or three "pips" between the ask price and the bid price. A pip is defined as 1/100th of one percentage point of a currency quote for most currencies, with exception of the Japanese yen, where a pip is equal to one percentage point of the currency quote.

With a fixed commission, for example, if the bid and ask prices on EUR/USD are set at 1.2576/1.2578, then the trader can buy the currency at 1.2578 and sell it back to the dealer at 1.2576, which nets a gain of two pips for the dealer. The bid/ask prices of the same currency pair might move to 1.2580/82, but the dealer will charge the same two-pip difference as a fee per unit of currency bought and sold. ^[1]

With a variable rate commission, the spread between the ask and bid prices can change according to the demand for the currency in the market. For example, EUR/USD might appear initially with a bid/ask spread of two pips at 1.2576/1.2578. However, depending on the demand and volume traded, it could change to a spread of three pips at 1.2585/1.288. Under this model, the spread often widens when there is greater liquidity in the market, such as when there are expected news events that might provoke price movements.

As for the percentage-based commission, it is a small percentage built into the wider spread. In this case, the broker takes the percentage that could amount to only a fraction of a pip. He then leaves the remainder of the spread to a larger market maker with which he's working. This type of commission can allow a trader in some cases to pay a lower cost of perhaps only one pip to make a trade on a given currency pair.^[2]

Making Profits

The level of commission paid could end up being critical in determining how much profit or loss a trader may register on a particular trade. In all cases, the price of a currency pair will have to move above the spread/commission costs in order for the trader to post a profit on a trade.

Regarding spreads, traders will encounter various situations. For example, highly traded currency pairs will generally be offered at narrower spreads. On the other hand, less common currency pairs with so-called "exotic" currencies may be offered with wider spreads.

The amount of profit or loss that can be realised won't depend on the spreads alone, however. Currency pairs with low spreads, for example, may tend to show lower volatility, and thus offer fewer opportunities for large gains or losses. At the same time, currency pairs with large spreads could show high volatility, offering more opportunities for larger gains or losses.

Choosing A Broker/Dealer And Commission Structure

Given that there are different types of commissions charged among brokers and dealers, traders may find it helpful to analyse what type of trading they plan to do before choosing which type of broker or dealer to work with. Some may offer features such as analytical tools that help justify higher spreads or commission costs. Traders may also want to consider whether they prefer to work with large volumes and lower spread and commission costs in more traditional and liquid markets; or risk trading in more volatile markets where the potential for gains and losses could be greater.