In the last few MarketPulse articles we’ve been discussing foreign exchange (FX) trading and why it has become the fastest growing topic of enquiry from Australian Stock Report members. This week we’ll investigate some reasons as to why this might be the case.
Not too long ago one had to be a big bank or financial institution to trade in foreign exchange, and it was largely considered somewhat off limits to the average investor. For most of us, the only experience we might have had with the concept was getting stung at the currency exchange kiosk before we jumped on a plane at the international airport! FX trading always seemed a confusing and complicated pursuit.
As with anything however, when technology gets involved, things just seem to get easier. With the advent of Contracts for Difference (CFDs) and the incredibly functional and technologically advanced platforms providers have offered, the average investor has suddenly become a major player in a number of financial markets once considered out of reach to them. The FX market is certainly one of these markets.
With the click of a mouse, a trader can now exchange one country’s currency for another over the internet. It all happens instantaneously, and we can then track the fluctuations in FX prices and breaking news from all over the world in real time.
‘Mums and Dads’ who have typically restricted themselves to investing in BHP, RIO, the banks, and Telstra, are now actively trading Japanese Yen for Swiss Francs and British Pounds for Korean Won! This certainly is the information age and it’s fair to say that technology is probably the biggest factor in the recent FX trading boom.
CFDs which have been at the cutting edge of trading technology have helped the boom, but also the leverage which CFDs afford. When trading in FX using a CFD, investors will often be able to trade with leverage of 100 times their equity investment. This means that with just $100, a trader can control around $10,000 worth of FX. Compare this with your average leverage on an Australian share CFD of around $1,000 required to control $10,000, and it is easy to see why FX trading appeals to investors with small starting banks.
FX trading can be broken down into the smallest bite size pieces and many FX traders are only risking $50-$100 per trade to make roughly as much. Many FX traders aren’t aiming to buy a tropical island with their FX trading profits, but merely to add an extra $300-$500 a week to their income.
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Following on from the new-found ease in trading FX, and the incredible leverage on offer, the next most important factor contributing to the FX boom is the miniscule costs associated with trading. Most investors think of brokerage when they think about transaction costs. When trading Australian shares, this is certainly a given as all share transactions attract brokerage. In addition, investors must also pay GST on brokerage.
Very few investors are aware that there is another, far more hidden cost to trading. It is the spread.
The spread is the gap in prices between where the highest bidder for an asset is showing they wish to purchase, and where the lowest seller is showing they wish to sell. For example, if BHP is trading at $39.99-$40.00, we would say that the spread is $0.01 or one cent. If we purchased 100 BHP shares and then immediately changed our minds and decided to sell, we would lose one cent per share or $1 (-$0.01 x 100).
The spread is a very real and unavoidable cost of trading for all market participants in all financial markets. Naturally, astute investors want to trade in asset classes which have the tiniest spreads, therefore minimising their costs to deal. After all, in the markets and in all aspects of life, a dollar saved is a dollar earned.
Spreads on Australian shares for blue chips like BHP and RIO which have relatively higher prices tend to be small, with the minimum spread typically as little as one cent. For BHP, this represents an unavoidable transaction cost of approximately 0.02%, and for RIO it’s approximately half that. Seems too little to care about? Compared to an FX pair like the AUDUSD which can be traded from as little as a 0.0001 spread, it’s roughly on par, but what about for lower priced stocks?
Telstra has a current share price of around $2.60. It also typically has a one cent spread. This however represents a spread cost of 0.38%. It might not sound like much, but when you consider that the average discount brokerage rate in Australia is approximately 0.10%-0.15%, the cost of the spread to trade TLS is up to 4 times greater than normal brokerage! I’ll bet you never thought of it like that before!
Let’s look at a more practical example. If we purchased 4,000 TLS shares for $2.50 (just to keep the numbers round) we would have to outlay $10,000. Most discount brokers would charge around $20 including GST for this trade. The cost of the one cent spread is $40 (-$0.01 x 4,000 shares). The trader has actually paid total costs of $60 to do this trade!
Of course many traders are trading in much lower priced stocks than Telstra. Consider a $1.00 stock which has a $0.005 spread. It has a spread cost of 0.5%. A stock which trades at $0.50 and a $0.005 spread has a whopping 1% spread cost! If you only have a small trading account, paying this much in brokerage is going to make it extremely hard to turn a profit. We’ve said it before, but in the markets, a dollar saved really is a dollar earned. Whether big or small, all traders need to seek out markets which have the lowest dealing costs. This is just good business sense.
Take advantage of low FX costs.
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FX spreads are miniscule, we know that. This makes FX perfect for traders looking to minimise their transaction costs. However, most investors who are new to FX trading don’t know that one can generally trade FX in a zero brokerage environment. That’s right, very few FX brokers (and no CFD providers) charge brokerage on FX trades. The only cost to the trader is the spread. Further, with no brokerage to pay, there’s no GST either!
So how do the FX brokers and CFD providers make their money I hear you ask? Well they build their commission into the spread itself. So apart from paying the spread (which you were going to have to pay anyway) there are no other costs associated with purchasing or selling FX.
Because of the above reasons, FX trading has boomed amongst retail investors. There are many other good reasons why traders are flocking to FX however, and we’ll discuss a few more of these in next week’s MarketPulse article.
In the meantime, if you would like to learn more about FX trading, or more importantly learn more from one of the most respected FX traders in the country, Australian Stock Report is proud to offer an exclusive FX workshop presented by Kel Butcher. The Fast Track FX Workshop is a one-day intensive training session which will show you all of the ins and outs of FX trading and give you a number of great short term FX trading strategies to help you trade profitably from the start. It certainly is a not-to-be missed event!
For more information on the Fast Track FX Workshop with Kel Butcher click here