Recently, I came across an interesting trading strategy, intended for futures trading but theoretically applicable to retail Forex trading. As a Forex professional, I took a closer look at the strategy to see what kind of edge it might have historically provided to retail Forex traders.
The results make interesting reading because they illustrate exactly why it can be so difficult for retail traders to exploit edges that exist within markets. A trailing stop should be used of 3 times the day ATR from the highest price since the trade was opened for longs , or the lowest price since the trade was opened for shorts.
Over trades, a total return of This means that the average trade produced a return equal to the amount risked plus an extra 9. Considering the strategy is completely mechanical, and that it represents only one instrument within what is traditionally the worst-performing trend-following asset class currency pairs , this is not such a bad result.
However, fees and commissions must be factored in, to determine the return that could actually have been enjoyed. This would mean a reduction of the return by only about 0. It could be assumed that if the rolling over strategies were less than perfect, there would be some additional losses. Luckily for this trader, the brokerage allows access to some kind of approximation of a futures contract that can be traded with a very small lot size, as well as very small lot size spot Forex trading, so there is no problem with scalability.
First of all we can look at the cost of using spot Forex:. For the sake of simplicity we can perform a rough calculation based upon pips. The spread alone is 2. Next, we must deduct the overnight swap charges.
Our retail trader had a position open over 9, nights, which would account for 7, pips. So we must deduct a total of 8, pips from our total profit of 9, pips, which leaves a net profit of only pips! For the sake of this rough calculation, if we assume that the return is evenly spread over each pip, this represents a greatly reduced net profit to our retail trader of only 3. Taking another look at the numbers and also assuming that one quarter of all trades must be rolled over, our retail trader would face a fee of 14 pips times, equaling a deduction of 6, pips.
This would represent a net profit of 2, pips. Assuming again that all return is spread equally over each pip, our retail trader ends with a net total return of 9. Furthermore, this return would be less than one third of the amount enjoyed by the large fund.
Why are things so bleak for our retail trader? There are several reasons, and examining each reason carefully can help any aspiring retail trader understand how certain edges within the market can be effectively whittled away by the wrong choice of brokerage or execution methods. Actual futures contracts are too large to be available to most retail traders, and position sizing cannot be achieved properly with amounts less than several million dollars in a diversified trend following strategy.
Mini-futures are a potential solution, but if they are not very liquid then they are unlikely to present the same trend-following edge as ordinary futures. This brings us to the topic of spreads. Brokers charging more than this really have no valid excuse.
It should be said that spreads in the retail sector have been going down in recent years. While this is good news, even if the retail trader in our example had been paying 1 pip instead of 2.
This brings us, finally, to the real culprit of the reduced return: When you make a Forex trade, you are effectively borrowing one currency to exchange for another. You must therefore logically pay interest on the currency you are borrowing, while receiving in return interest on the currency you are holding in return. There is usually an interest rate differential between the two currencies, which means you should either be receiving or paying some extra fee each night representing the differential, and of course the exchange rate is a factor as currencies rarely trade at 1 to 1.
The only time there would be nothing to pay or receive would be if the exchange rates were exactly equal at the rollover point, and there was no interest rate differential.
It would seem that sometimes you pay the difference and sometimes you receive it, so overall this swap cancels itself out. Unfortunately it is not as simple as that, for several reasons:. Currencies with higher interest rates tend to rise against currencies with lower interest rates, so you tend to find yourself in more long trades over time where you are borrowing the currency with the higher rate of interest, meaning you tend to be paying more often than receiving. Retail Forex brokers charge or pay quite wildly different rates to their clients long or short of a particular pair.
Many brokers are very opaque about this and do not even display the applicable rates on their websites, although the rates can be found within the brokerage feed on every MT4 platform. It is worth mentioning that, to be fair, there are legitimately different methods of calculating this charge.
However if you look at the table compiled at myfxbook showing a range of overnight rates charged by some retail Forex brokers, you will get a sense of the wide variety in the market.
Ironically, these tend to be the same brokers that will bill you for account inactivity, and exactly what administration is involved when the trades are rarely even booked in the real market is highly questionable. The end result is to skew the fee even further against the client. Most traders are highly leveraged, which means that they are borrowing the vast majority of the currency they are trading. Traders tend to forget that one of the negative consequences of leverage is to push up the overnight swap charges, as they must pay interest on all the borrowed money, and not just the margin that they are putting up on the particular trade.
Of course, this is a legitimate element of the charge. The practice of charging a fee for every night a client keeps a position open is not only open to abuse, but can be an effective way to dramatically reduce the odds that a trader might seek to move in their favor by an intelligent use of long-term trend trading, which usually pays off over time if executed properly.
It might be said that some retail brokerages are using the widespread ignorance about these charges as a way to add to their balance sheets, and that regulatory agencies should be taking steps against this. On the other hand, it could also be said that a market maker cannot be expected to make a market in a way where they can be systematically put out of pocket by the long-term statistical behavior of the market. It might be that many of the differential rates between brokers are reflected by the currencies that their clients are long or short of at any particular time.
It can be seen that one broker might be offering a better deal than another on one currency pair, but not on another, which seems strange. A systematic study of this area would make a very interesting read. Meanwhile, a retail trader seeking to systematically hold positions overnight should make sure they fully investigate what is on offer when they are shopping around for brokers, and be aware that the speed of a price movement in their favor can have a big effect on the profitability of any trend or momentum strategies that they might be utilizing.
Adam is a Forex trader who has worked within financial markets for over 12 years, including 6 years with Merrill Lynch. Learn more from Adam in his free lessons at FX Academy. Honestly it was not surprising for me to see this article, as every non ECN broker is going to do this, therefore if we want to trade stress free go with a regulated and a true ECN company.
They offer great swap free account, so we can keep our traders for us long as we wish to without any charges. Must read for anyone that really wants to understand how the system works.
Definitely makes me think I need to know better how does my broker is building my fee charging structure. Registration is required to ensure the security of our users. Login via Facebook to share your comment with your friends, or register for DailyForex to post comments quickly and safely whenever you have something to say.
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For the sake of full disclosure I reproduce the strategy rules in full: First of all we can look at the cost of using spot Forex: Each trade incurs a spread of 2. Breaking it down Why are things so bleak for our retail trader? Overnight Swap Charges When you make a Forex trade, you are effectively borrowing one currency to exchange for another. Unfortunately it is not as simple as that, for several reasons: Adam Lemon Adam is a Forex trader who has worked within financial markets for over 12 years, including 6 years with Merrill Lynch.
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