The Basics

The Cost of Trading

Last week I wrote a post for the Currensee blog addressing a recent SmartMoney article attacking forex trading from the perspective of costs. The article was full of misinformation of the sort I’m coming to expect from those writing about forex (and trading in general) from a journalistic point of view. I wasn’t shy about taking the author and her editor(s) to task for the piece’s short-comings.

One of the core elements of the discussion in my post was the impact of spreads on one’s trading. In the spot forex market spreads are readily visible because that’s how the market presents price feeds. In exchange-traded markets, however, spreads are often quite opaque because it’s traded prices that are the dominant presented part of prices feeds. The fact of the matter is, however, that bid/ask spreads exist in all markets.

Over the last couple days I’ve been collecting spread indications from a wide array of markets at random 15-30 minute intervals during the NYSE trading day (to ensure that all markets involved are open and active rather than including pre-market and other non-primary sessions). Here is the result of the study including some of the most actively traded market instruments.

The equity instruments were selected based on regular inclusion among the most actively traded securities (on a shares basis), so the list includes a couple of index ETFs as well has high profile individual stocks. The Treasuries list includes the current on-the-run securities, meaning the ones most recently auctioned. The futures prices are for the standard contracts except where specifically noted. Prices for the noted forex exchange rates are from the EBS dealing system. All of the above information was derived from real-time prices. (Keep in mind that markets less active than the ones presented here will tend to have wider spreads.)

The Data
I’ve a couple of primary sets of information in the above table. One is the spread. In order to standardize the comparison, I’ve expressed that in terms of the dollar value of the spread relative to a $100,000 trade. Obviously, these securities trade in a wide array of different contract and position sizes, so this isn’t meant to indicate some real-world fixed contract value. The $100,000 was just selected to make the spread values as expressed in dollar terms easy to understand and compare side-by-side. The “Avg $ Sprd/$100k” column shows what the average spread was based on about 30 intraday observations, with the “$ Sprd Rng” column indicating the range of spreads observed.

On the right side of the table I’ve incorporated broker commission estimates to provide a second set of comparative information by way of total trading cost. I’ve used $7.95 per side for the equity trades and $7.95 per round turn for the futures contracts. Brokers often will do commission-free transactions for Treasury trades, so no commission is factored in there. Similarly, zero-commisson trading is readily available for retail forex trading, so no commission is factored in there either. Obviously, the reader can replace what I’ve listed with their own numbers for a more personal comparison.

And the winner is…
If you want lowest cost trading then you want to stick to the short-term interest rate market. Spreads on 2yr and 5yr Treasury Notes are under $10 for a $100k trade, and they average under $3 for 3mo Eurodollar futures (note that this is Eurodollar, not the EUR/USD exchange rate). It’s worth noting that these are the very same markets where my volatility comparison between markets shows the lowest levels of volatility.

Beyond the short-term rates securities, the all-in cost of trading for the major forex pairs holds a modest edge over most of the other instruments included in the study. The futures markets, however, are mostly fairly close. It’s in the individual stocks where we start to see the total costs extend away from the overall group average, largely because of the broker commissions.

Market maker’s dream
Of course the one figure jumping off the page is the spread cost of Citi (C) stock. The bid/ask spread is $0.01, and the stock is (at this writing) trading below $5. That means the spread value is quite a bit higher than the same spread for the Qs trading in the $50s. Now consider that 350-400mln shares of C traded during the period of the study. That’s better than $1.7bln worth of volume. At about $205/$100,000 we’re talking about something around $3.5mln in spread differential per day!

It’s good to be a market maker in Citi shares these days!

Factoring in leverage
Note that in now way is leveraged trading factored into the figures above. They only reflect costs per $100,000 traded. That means costs as related to the value of one’s account is going to depend on how much leverage is being applied. For example, someone trading $100,000 worth of EUR/USD on a $10,000 account (10:1 leverage) will have a cost of about 0.1% ($11.10/$10,000). Similarly, someone trading $100,000 of the SPY on a $25,000 account (4:1 leverage) would have a cost of about 0.09% ($23.14/$25,000). To fairly judge the cost comparison between markets, one needs to do so on the basis of how much leverage is being applied and how frequently trades are being done.

Trading Tips

Reaction to the “worst analysis” post

My post from yesterday, Some of the worst market analysis ever!, generated a bit of a response (I’ve also noted that another blog picked up the post to which I was reacting). While my main focus was on showing readers of this blog the sort of analytic pitfalls one can fall into, I’ll admit that picking a bit of a fight with Zero Hedge was on my mind as well. I didn’t really expect a reaction, as I’ve written about the posts there before without any, but this time someone actually made note of what I said in the comment section of a ZH follow-up post on the same subject. That generated a few reactions there.

Actually, one reaction was left as a comment on my post. It was left by someone who apparently is very shy because he/she left no name and a bogus email address. The comment was

“um you trade them in a ratio, the author assumed you would get this.”

I can perhaps understand the commentor’s reluctance to attach their name to this brilliant bit of insight which has absolutely nothing to do with the problem I have with the analysis in question. It speaks not at all to the whole “risk free” question, nor does it address the viewing of converging lines on a dual-scale chart as representing a spread going to zero.

On the ZH site the author left his own reaction to someone named sumo posting my assertion “There is absolutely no mathematical or other direct linkage between the S&P and EUR/JPY.” At least I think it’s the author. As I understand it, several people actually author on ZH under the same nom de plume (that’s pen name), so it could have been someone else on the staff. In any case, the response was:

“I assume the gentleman has never heard of the carry trade and its implications.”

Hah! We’ll leave out a discussion of the fact that I was in the forex market long before “carry trade” became common parlance and focus on the mechanics.

The assumption implied by the above statement is that all carry trading is done through stocks. It most definitely is not. In fact, the simplest and easiest carry trade is to just borrow the low interest rate currency and invest the proceeds in a debt instrument of the higher interest rate one. The carry trade need not have anything at all to do with stocks. That means, as I indicated, there is no direct linkage between the S&P 500 and EUR/JPY, meaning carry trade related movement in the likes of EUR/JPY need have nothing at all to do with the stock market. It can move independently. The current market environment is such that the risk tolerance of traders/investors creates a common driver of action in the forex and equity markets. Were something to happen like a Bank of Japan rate hike, however, there could be a very serious sell-off in EUR/JPY on yen appreciation which probably would have a very minimal impact on US stocks.

I’m not sure whether this comment by aldousd was directed at me:

“it’s ridiculous to say that it isn’t related. it’s been going on all day. I keep reading people saying that it’s a coincidence… a second by second coincidence.”

In case it is, though, I certainly never said anything about “coincidence”. In fact I noted that the drivers for the comparable moves are similar.

There’s another reaction offered up by BeerGoggles to the first comment posted:

He’s going on about zero prices as well and clearly has never looked at the ATRs of EJ and S&P.

I have no idea what this person is going on about. I definitely didn’t say anything about zero prices. Maybe he’s referring to the author, but aside from talking about a zero spread (which I contend is incorrect) I don’t recall him saying anything about zero prices either. For the record, though, as of June 7 the normalized 14-day ATR (meaning ATR expressed as a % of the 14-day average) was about 2.8% for the ES and a touch under 2.5% for EUR/JPY.

Here’s a comedian:

Does he use charts for his trading, or some secret method of essentials we haven’t yet heard of?

Whitty, but the incorrect application of the charts is exactly the problem I have with the analysis. For the record, I use charts all day, every day.

Here’s someone who gets it:

I’m not a trader or an FX expert, but I do know maths and you guys are missing the point.

What the “non-fan” is saying, is that a graph of two variables NOT on drawn on the same scale, is going to lead the observer to false conclusions about trading opportunities when they see a gap. It’s perfectly possible (and in this case highly likely), that you’d loose money by trading ONLY based on the existence of a large gap.

By all means do all the carry trades you wish, but not based solely on this gap information. You need more information to guarantee an easy trade.

Thank you virgule (commentor’s handle)! In case you were wondering, “non-fan” is me. 🙂

As I said in my post yesterday, it’s not about whether doing this kind of pair trade is the right thing. It’s about not employing faulty analytic methods to get there, and not thinking that this is a zero risk arbitrage trade.

Trading Tips

Some of the worst market analysis ever!

I came across an article the other day which got my blood boiling a bit. It basically talks about trading the “spread” between the S&P 500 and EUR/JPY forex cross rate. The author was quite happy with himself for calling the spread being exceedingly wide and recommending a spread narrowing trade. He went so far as to say “Selling ES and going long EURJPY is now pretty much risk free.” I don’t know what anyone else’s definition of “risk free” is, but this trade certainly isn’t mine.

I don’t have any problem with the general idea underlying the trade that stocks and the EUR/JPY rate tend to trade in tandem. It’s been the case for quite a while now that when the market’s are feeling good and buying stocks EUR/JPY (and really all the JPY pairs) will rally, but when the markets are nervous and shifting into a risk aversion mode both the exchange rate and the stock market falls.

My issue with this analysis is this. The author is using a dual-axis plot of the S&P and EUR/JPY (meaning two price plots with different y-axis) to determine the “spread”. When there’s a gap between the lines there’s a spread. When there isn’t, the spread is zero. That would all be just fine if the S&P 500 and EUR/JPY were even close in price, which they aren’t.  At this writing the mini S&P contract is at about 1066 while EUR/JPY is right around 110. Notice how they are not anywhere close to zero?

This has got to be some of the worst analysis I’ve ever seen. Please, please, please don’t every employ this methodology – if you can even call it that.

And calling or implying this trade is some kind of arbitrage is even worse. There is absolutely no mathematical or other direct linkage between the S&P and EUR/JPY. That means no arbitrage, just a coincident relationship. It just so happens that in this market cycle they are trading based on the same main drivers. That could change at any time. That means you most definitely have risk.

Again, I’m not necessarily arguing against the idea of the trade (stocks and cross get back in line). I’m just saying the analysis used to get there is severely flawed and dangerous.

Reader Questions Answered The Basics

The Cost of Forex Trading

I was asked by frequent emailer Rod to address something he came across regarding the cost of forex trading as compared to trading other markets, like futures. He is referring to this blog post in which the author compares retail forex to emini S&P 500 futures. In particular, the following statements are made:

“…unlike a stock, option or futures trade where one pays to enter and again to exit (but not to hold) a FX position is inherently a short-term trade, as you will be charged simply for the privilege of holding your position open over a period of time.”

“If you short the Euro/USD cross, for example, and expect a 100 pip (one cent) move on your trade, you might pay three pips of spread to enter and another three to exit, for a total “vig” of six pips.  That’s a 6% commission!

There’s plenty for me to address here.

Spreads and Commissions
I’m going to start with the second quote first because there is one blatant error, and other less obvious ones.

First of all, you don’t pay two spreads. In fact, you don’t really “pay” a spread at all, though certainly it is a cost. The only time the spread impacts you is when you first open a trade. Let’s say the market is at 1.4500-1.4503. If you go long, you will enter at 1.4503 ask/offer price. Now in order to exit your long you would sell at the bid price of 1.4500. As a result, you have a 3 pip loss from the outset. That’s the only time the spread comes out. If the market moves to 1.4600-1.4603 – the 100 pip gain noted in the quote – you would exit at 1.4600 for a net gain of 97 pips, not 94 as suggested.

Second of all, the 6% calculation is based on being leveraged at 100:1. I’ve already shown that the spread loss is not 6 pips, but rather only 3, so that cuts the cost to 3% on a fully leveraged position. Most traders, however, don’t go anywhere near 100:1 leverage. Experienced folks often limit themselves to 10:1-20:1. At 20:1 the spread cost is 0.6%, while at 10:1 it’s only 0.3%.

But wait! The 6% calculation is also based on erroneous figures. It assumes that a full contract is worth $100,000 and a pip is $10. The value of a full EUR/USD lot priced at 1.4500 is $145,000, for which $1450 would have to be posted as margin at 100:1 leverage. A 3 pip spread value of $30 on that full contract would thus only be about 2%.Going with the lower 20:1 and 10:1 leverages noted above, the more realistic cost for the trader is 0.4% and 0.2% respectively.

Thirdly, the blogger fails to account for the fact that futures have spreads too. I see this happening all the time – people claiming that other markets don’t have spreads, or simply being ignorant of the fact. The usual spread in the e-mini S&Ps is a quarter point, or $12.50. The round-turn commission the blogger mentioned in his post was $6, so when you factor in the spread cost you get $18.50. That’s about 0.4% when the blogger’s $4050 initial margin requirement is applied. Looks pretty comparable to me.

Carrying/Holding Costs
Now back to the subject of the first quote. The blogger is correct that there isn’t a carrying cost for trading stocks (unless you’re doing so on margin, in which case you have interest expenses). There is carry for all the other markets, though.

In options time decay is a cost of carry for those long the option, but a benefit for those who are short. In futures there is a spread between the contract price and the spot market price, which moves to zero as the contract nears delivery. In some cases the spread is positive, while in others it’s negative. Obviously, the forex market has daily roll-over/carry which can either go for or against the trader depending on which way the interest rate spread is going.

In other words, unless you’re a short-term trader, there is a carry involved in all the markets except stocks. To claim otherwise is to be misinformed.

Cost Competition
Keep in mind too that it behooves forex brokers to be price competitive when compared to futures. If not they stand to lose especially their bigger customers (and thus their bigger volume) to the futures market.

The bottom line is that retail forex trading is pretty comparable in terms of its costs to other markets available to individual traders. If you have any doubt about that, do the math for yourself based on your own trading.