Friday, November 10, 2006
What commission does to your investment capital
What commission does to your investment capital
(Because stocks do not have a universal set of commission costs per trade, I will be using the Foreign exchange markets to get the point across. It doesn’t matter what you are trading, fees exist in all markets!)
I frequent several online forums, a few for trading and economics, a couple politics discussions but in the trading forums I see so many posts of people who are ready to leave the markets because of failure.
Investors have been sucked into the forex markets through only greed. Most new investors go right to trading after only reading a short ebook on the subject. To make matters worse, it is estimated that only 10% make money in the forex markets, the other 90% lose some and quite a few of that 90% lose it all!
Forex is advertised as a market without fees for trading. This is of course untrue as no broker stays in businesses without charging money to trade. Forex commissions are quite different however, they are automatically priced into the price of the currency pair you are buying or selling. Forex works with things called pips, or the smallest unit in a price. In stocks this would be like the penny or cent.
Most brokers charge anywhere from 2-5 pips for buying and selling pairs. This works out to $20-$50 per lot of 100,000 units of currency. The spread is kept by the trading firms to ensure they can make money as the middle man.
Back to the main topic:
Most new traders seem to quit so soon because of lackluster performance. In 95% of these threads there is a reoccurring trend. Most new investors trade very short term charts!
The years 1999 and 2000 changed investing forever. The technical age was booming and everyone was interested in “day trading.” Every magazine depicted day trading as an elite activity. People were making millions a year just by buying large quantities of an equity and selling just after a few minutes to hours for very small gains on each individual share. Volume was the key to success with day trading, buying 10000 shares of Microsoft meant that an investor could make $5000 just with a .50 rise in the share price.
Now I go forward to today and every new person to the forex markets loses it all in just a few weeks. I have a reason for this:
When you buy a pair on the foreign exchange markets, you pay a little bit extra due to the spread. Everyone knows this, and if you didn’t, reread the top of this post 
When trading in short time periods, you are usually looking only for very small gains on the equity you have purchased. Through volume you plan to make a killing on your overall investment.
If I am a day trader looking to make 10 pips on an investment, I have to make 13 pips to reach that goal. Buying in costs me 3 pips as it is, so the price must rise 13 pips in order for me to make 10 pips. I’ve started off the investment at a loss.
This means that my commission accounts for 23% of the gain of the currency pair.
Forex is, I believe a positive odds gain because of the amount of money that is spent to keep currencies between certain price points. Governments and banks are willing to lose billions to keep their currency prices where they need to be to promote economic growth. This is another story for another day.
What we need to know is that markets are basically 50/50 investments. There is a 50% chance the pair will drop and an equal chance it will rise at any one time. The universe just works like this.
Now lets apply what we know to our profit taking:
Let’s now assume I am a swing trader so I’m looking for roughly 50 pips from each trade. Each trade costs me 3 pips just like last time.
My pair must rise in value 53 pips to reach my profit point. This time, because of my increased timeframe, the spread only accounts for 5.6% of the gain.
This time commission accounts for 5.6% of the currency pair gain!
The informed investor has plenty of ammunition behind him or her to overcome a 5.6% deficit. Through utilizing charts and analysis the average investor can find a plan to win more trades than just 55%.
I am certainly not much more than a part time investor. Granted I do trade for a living, I am not an investing god. I can consistently win about 95% of my trades but I do not take many trades.
The moral to this story is to be patient. One great trade is always better than three mediocre trades. Figure out how much commissions are affecting your bottom line and work to increase your profit to commission ratio.