The underlying service that financial brokerages provide, as their name implies, is the brokering of customers trades, the process of which is described as trading.
As traders engage in this process of buying and selling financial markets products through their brokerage, there exist costs and fees to execute such orders, and brokers typically will add a spread or commission to their underlying costs, if any, in order to net a profit for the services they provide to end traders who are their customers.
The spread is the difference between the BID price and ASK price, which are the prices where an instrument can be sold and bought, respectively. This spread can be a fixed amount, percentage or variable amount, or both, and represents the cost to trade the specific instrument.
Whatever the spread is at any given time, it represents the cost that would be incurred to open and close a position in that instrument, at that moment, by marking-to-the-market (MTM) the trade at the moment it is established (even if the spread or rates change the next moment).
Example Spread Cost Using Trade Example:
For example, if a trade was executed to buy 10,000 units of EUR/USD at an ASK price of 1.3455 and at that same moment the bid price was 1.3450, then with a spread of 5 pips, the costs can be said to be that difference because at the moment that trade was opened the price where it could be sold was 5 pips lower, which would have netted a loss of that amount (1.3455 minus 1.3450 =0.0005 pips).
Whether the market moved at the next moment 5 pips higher (bid 1.3455/ ask 1.3460) which could enable the trade to be closed at a break-even (no profit or loss), or whether it moved 5 pips lower at the next moment which would cause a 5 pip loss, the spread must be added to any profit or loss. In this example, a move higher enabled a break-even, whereas a move lower caused a 5 pip cost to become an overall 10 pips loss (5 pip spread +5 pip market move).
Therefore, the spread and understanding how it can add to your trading cost, as well as how it is charged, in theory, is an important part of managing your trading.
Difference Between Spreads and Commissions
In addition to spreads, commissions are either fixed dollar amounts or percentage of trade values, which are added to trades that are established, such as when opening and/or closing a position. While some firms, may charge only spreads, and others only commissions, and some firms may charge both, the overall sum of charges should be noted. Yet this alone may not be indicative of the quality of the service or execution.
Nonetheless the two principal costs of trading are spreads and commissions, and thus traders should ascertain from their broker what the spreads are if any per tradable instrument offered by their firm, and/or what the commissions are for all available products.
What are Rollover or Premiums and How Can They Add Up to Trading Costs
One additional cost associated with trading in a margin account are financing costs, known as rollover rates or premiums. These charges are applied to trades that are held past intraday, generally 4pm EST, although can vary from provider to provider, and can be either a negative (debit) or a positive (credit) applied to a traders account and charged based on the number of trading days a trade is held open.
These rollover costs can sometimes be positive, for example when trading certain currency pairs where there is a significant interest rate differential between the two underlying currencies involved in a pair – there may be a positive interest paid on one side of the trade, such as in the case of buying the base currency. On the contrary, selling the same base currency in that pair would incur a cost or negative premium charged against the account.
Overview of Trading Costs:
Spreads: Difference between Bid/Ask Prices when trading occurs, can be different per instrument
Commissions: Fixed Dollar amount or percentage fee added to each trade can be different per instrument
Rollover: Cost of Carry premiums and financing costs can be different per instrument and positive or negative depending on direction of trade
Additional Information about Rollover and Financing Charges
In addition to spreads and/or commissions that add up to the cost of trading, traders should be aware of what the rollover and financing charges are to carry trades overnight or past the settlement time when such rollovers are applied.
Furthermore, some trading days have multiple rollover days applied such as on Wednesday, or in the case of certain national holidays for one or more of the currencies involved in a pair, or other trading instrument such as an Index or CFD – where the underlying market may be closed that day or the following day.
The Financial Commission examines the spreads, commissions and/or financing charges when needed when reviewing a related trading complaint or dispute where such information is relevant to understanding the issue at hand, and where the fault if any is found.
In closing, by understanding the overall costs involved with trading, including how rollover rates are applied, and what are the exact rollover rates for buying or selling the available trading instruments, traders can better plan their strategy and take such costs into consideration.
Whether this brokering is done in an agency, principal, exchange or other business model, regardless of the venue type, or method for routing the order, spreads and commissions have come down considerably, but is not always indicative of the best quality service or execution efficiency.