Understanding How the Forex Brokers Make Profits

When you start currency trading, you are told by every forex broker that there are no commissions involved in forex trading. New traders take their brokers words as true and most think that the cost of trading is minimal.

Forex brokers also called FCMs (Futures Commission Merchants) make profits through the bid-ask spread they offer to their clients for each currency pair. This bid-ask spread is the trading cost for you and the profit for your FCM.

Lets do a simple calculation. Spreads are usually overlooked by the individual traders as the price they pay for trading. So lets calculate your cost of trading.

Suppose, you are day trading the currency markets, 5 times every day. Take away the weekends, when you cant trade, there are 250 trading days for you.

As a day trader, you open and close your position before the end of the day. That means each position is traded 2 times.

Suppose; your start with a deposit of $50,000. You use a leverage of 4 only, you are being cautious. So this $50,000 deposit will control (50,000) (4) = $200,000.

Your Annual Turnover will be; (5) (250)(2)(200,000)= $500 M. Huge! Now lets calculate how much your broker will make and what your spread cost is. Spread Cost= (Annual Turnover) (spread)/2.

Suppose further, the bid/ask spread offered by the broker is 3 pips. 3 Pips Spread Cost= (500M) (0.0003)/2= $75,000.

Suppose, the spread offered by the broker is only 2 pips. 2 Pip Spread Cost= (500M) (0.0002)/2= $50,000.

The cost of trading with a 3 pips spread versus a 2 pips is $25,000. This is 50% of your account equity. You can see yourself that a 1 pip difference can result in $25,000 more of trading costs.

You will need to make a profit of $75,000 simply to break even with a 3 pips spread. Trading costs are one of the primary reasons most active traders fail in the long run.