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An Analysis of Trading Cost and Trading Risk

High Trading Cost and High Risk are your Worst Enemies

These two factors are responsible for traders who lose money in the long-run and they will be analyzed below. But first, let’s see our latest signal on GBP/AUD.

Today it is the 13th of June 2013 and at about 1.00 pm when this analysis is written, GBPAUD is found at 1.6380 which means at the same price as the starting price of our signal. During the past days, it has reached the 1.6670 (11th of June). What happens next will be an outcome of the upcoming news and as from now, the technical analysis can be considered neutral in terms of the direction and highly aggressive in terms of the upcoming fluctuations. In whatever direction GBPAUD moves in the following days, its fluctuations are expected intense. That means value-trading for pros and a very risky environment for beginners and semi-advanced traders.

Here is the GBPAUD Signal »Signal on GBP/AUD (British Pound against Australian Dollar)

 


The Trading Cost and Trading Risk Becomes Greater in Short Periods of Time

The Trading Cost when trading common stocks or other similar non-leveraged financial assets is limited. But when comes to derivatives, the trading cost charged can really make the difference. The reason is that most derivatives are designed to trade short periods. Trading short-term means executing a lot of trades and that means a great trading cost in overall.

Measuring the Cost in terms of the Spread Charged

The cost of derivative trading includes mainly the spread between the Ask and the Bid. It may also include trading commissions sometimes but in our following analysis, we will assume that no trading commissions are charged.

In Forex when trading the most popular pair, EUR/USD, the trading cost in terms of the spread, is general from 0.5 minimum to 4 pips maximum. You may find even narrower spreads but remember that we assumed no-trading commissions.

In other words, the spread on EUR/USD is from 0.00005 to 0.0004 of the actual value of the trade.

■ The spread counts about 0.00005 to 0.0004 of the value of the Trade


An example of EUR/USD

To show up our case we will assume an average spread of 1.5 pip on EURUSD without commissions or other fees charged.

A trader opens a Forex / CFD account by depositing $1,000.

Now if this trader opens a position of one micro lot ($1,000), he will pay:

■ $1,000 X 0.00015 = 15 cents USD

But no derivative trader opens an account worth $1,000 to open positions worth $1,000. So if we assume a deposit of $1,000 and that an average trader uses leverage 100:1 he will open an average position of 1 standard lot ($100,000) then the trading cost in a EURUSD trade of 1 lot will be:

■ $100,000 X 0.00015 = 15 USD

It seems like a reasonable cost given the profit potential. But the thing is that this is the cost of a single trade. Usually, day-traders and especially beginners are executing tens of trades each day. Let's assume 5 EURUSD trades per day.

■ 5 trades X 15 USD = 75 USD

In just a trading week (5 days) this trader will have pay:

■ 5 days X 75 USD = 375 USD

In overall, the trading cost for a trading week will count of 37.5% of the total value of this trader’s account.

It is obvious that even in the most competitive trading asset (EURUSD) the trading cost can be disastrous when executing a lot of trades. We assume no profits and no losses. Why? Because in the short-term you are exposed to what is called the “Market Noise”. Market noise cannot be forecasted and thus cannot be traded profitable, especially as concerns non-professional traders.


Trading Intraday is like Predicting an Ongoing Earthquake

Market Noise acts as an earthquake, it can not be predicted and it should be avoided.

And to support this point of view with some evidence here is an interesting comparison chart. In the upper chart, we may see EURUSD 1-minute change (%) for a single random day. In the lower part of the chart, we may see a random Earthquake that took place in Western Nevada during the last days of September 1994.

Chart: Trading Short-Term Trading is like predicting an Ongoing Earthquake


The Trading Risk

The Trading risk also becomes greater in the short-term. The right stop-loss orders can make a huge difference when managing your risk. So here is a tip that suits all kind of derivative traders:

“(i) Leave space for your stop-loss, and (ii) Don’t place your stop-loss below the first support level, place your stop-loss below the second support level”

If you do what most traders do you will not succeed, you must constantly diversify your strategy and your way of thinking.

“You must act and think as the 5% of all traders not as the rest 95% does”


How You Can Minimize both your Trading Cost and Risk

First of all, you must find and review a broker that suits you best. You may use our reviews or other reviews to find the perfect brokerage service. The perfect broker should not be highly competitive but also to offer high safety of your funds. High regulation from trusted authorities may cover that field. Here are some pieces of advice for minimizing your trading risk.

1) Open an account depositing no more than 5%-10% of your total funds. That means that if you hold $10.000 you should open an account by depositing $500-$1,000.

2) Prefer a micro or a mini-lot account if you are a beginner. It’s not a shame to trade mini or even micro-lots if you are a beginner or a semi-advanced trader.

3) Minimize your trading action and avoid trading intraday. As it is analyzed above when you trade intra-day you are exposed to the ‘Market Noise’ which cannot be forecasted.

4) Place small trades and give your stop losses some space. If you trade using very-high leverage you will be forced to place your stop-loss close and that leads to greater exposure in terms of Market Noise.

5) Your trades should be able to offer you a Profit / Loss ratio more than 2 and that means:

■ {Profit Potential – Spread} > {2 X (Loss Potential)}

6) Learn about when important news is about to be released and adapt your trades to take advantage or avoid them.

7) Place your orders respecting major support & resistance levels. As we mentioned earlier place your stop-loss order below the second support if you buy and above the second resistance if you sell an asset.

8) Use a strategy that takes advantage of the Mid-Term trend and do not try to trade the short-trend. Don’t become day-trader unless you can predict the future. But if you can predict the future why losing your precious time with trading?

 

■ Giorgos Protonotarios, Financial Analyst

for Trading Center, 13th of June 2013


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