Cost of Trading
The main cost of trading with an online foreign exchange broker is the spread. The spread is the difference between the price that a financial product can be purchased and the value at which it can be sold. The price to purchase a financial product is called the ask price and the price it is sold for is referred to as the bid price. The spread is how the broker makes money on the trade orders you are placing with them and varies greatly between brokers. Some brokers will also charge a commission on each trade order they execute for you. Usually this is done with professional level trading accounts that have $50,000 or more in capital and come with lower spread costs. Most brokers will not charge a commission on trade orders placed with lower capital level trading accounts. The minimum amount of money you will need to open a beginner level account ranges from $100 to $500 typically.
The Spread and Pips
The spread will always be given in units called pips. A pip represents 1/100th of 1% and is referenced from the fourth decimal place in a currency pair quote. For example, the currency pair EUR/USD is quoted at 1.3387/1.3389 which means that you can buy 1 Euro for 1.3389 US dollars or you can sell 1 Euro for 1.3387 US dollars. The difference between the buy price and the sell price or the ask price and the bid price is 0.0002 which would be expressed as a spread of 2 pips. Pips will also be used as the unit to describe gains or losses with your investments.
A broker’s physical location can also be an important factor in selecting the right broker for a couple of reasons. You want to have a good internet connection with your broker of choice so that orders placed are executed right away. Things change fast in the foreign exchange markets and you don’t want to miss out on any profitable pips because of lag time between you and your broker. Also, spread values are different from one currency pair to another with the same broker as well as being different between brokers. A broker based in the United Kingdom will most likely have a larger spread on the USD/CAD currency pair than a broker based in the USA.
Leverage, Good and Bad
All brokers will offer some degree of leverage based on your credit up to a maximum limit for the broker. Maximum leverage amounts vary a great deal from one broker to the next topping out at around 500:1. Leveraging your limited capital to make money on money you do not have is an incredible opportunity, but before jumping in and buying 100,000 Euros with 500 US Dollars, there is a significant down side. Sure, you can make a ton of money on the fluctuating value of 100,000 Euro but if things do not go as planned you may lose the entire 500 US you put in plus any further losses taken before the broker was able to close your position. A margin account is required to use leverage and funds will need to be deposited to cover the minimum margin level which is a pre-defined percentage of your investment. If your investment loses value to the point that the capital in your account does not cover the minimum margin amount then you will get a margin call from the broker which means that you will be required to deposit more funds in to your account or the broker will liquidate your investment. It is your responsibility to maintain the minimum margin amount and your broker likely will not consult you before closing your position on an investment to limit the amount of loss taken. Movement comes fast in the foreign exchange markets which can be good or bad depending on the direction things move. Losses are a part of the big picture in foreign exchange trading and as long as you use proper risk management techniques, you will be able to continue to invest and off-set your losses with some good profits.
Finally, the foreign exchange market is not actually one single market, but multiple markets based all around the world. This fact makes it virtually impossible for a single group or organization to regulate the activities of all brokers and unfortunately opens the door for unethical people to take advantage of you. For the best protection possible, insist that your broker of choice be a member in good standing with the regulating body for the country in which they are based and doing business. The following are a few of the main regulators:
USA – U.S. Commodity Futures Trading Commission (C.F.T.C.), National Futures Association (N.F.A.), U.S. Securities and Exchanges Commission (U.S.S.E.C.)
Canada – Investment Industry Regulatory Association (I.I.R.O.C.)
UK – Financial Conduct Authority (F.C.A.)
Japan – Financial Services Agency (F.S.A.)
Australia – Australian Securities and Investment Commission (A.S.I.C.)
Never invest money that you cannot afford to lose…