Introduction to Spreads, Floating Interest and Slippage

Margin trading is one of the most common ways to invest in the foreign exchange (forex) market. Margin refers to the amount required to open a leveraged trading position, which is the difference between the total value of the investor’s position and the funds borrowed from the broker.

 

When engaging in margin trading, investors need to pay interest based on the borrowed amount. Therefore, before trading, investors should consider fixed interest costs and other transaction costs. Even if the purchased contract retains its value, it may still result in losses due to overnight interest costs, affecting overall profitability.

 

To accurately estimate transaction costs and make informed trading decisions in forex margin trading, it’s essential to understand the leverage principle and consider the following related expenses:

 

1. Spread

The spread refers to the difference between the buying price and the selling price of a forex contract. It is one of the profit sources for forex brokers.

When participating in forex margin trading, you pay the spread as a transaction cost. The size of the spread depends on the liquidity of the trading pair and market conditions.

Major currency pairs typically have lower spreads, while less common currency pairs may have higher spreads. Essentially, the spread in forex exchange acts as a transaction fee.

Calculation method for spread:

The spread is usually expressed in “pips,” where one pip represents the smallest price movement in a currency. For example, if you’re trading the EUR/USD currency pair, and the current buying price is 1.08397, and the selling price is 1.08387, the spread would be 0.0001 or 1 pip. The calculation is simply the selling price minus the buying price.

 

2. Floating Interest

Overnight interest is based on the interest rate difference between the currency pairs held. It represents the interest you need to pay or receive.

If you buy a high-interest-rate currency while simultaneously selling a low-interest-rate currency, you may receive overnight interest income. Conversely, if you sell a high-interest-rate currency and buy a low-interest-rate currency, you’ll likely need to pay overnight interest.

Calculation method for overnight interest:

Overnight interest is typically calculated based on the trade size and interest rate differential. Generally, you can use the following formula:

Overnight Interest = Trade Amount × (Interest Rate Differential / 100) × Overnight Interest Rate

3. Slippage

Slippage occurs when the actual execution price of a trade differs from the expected execution price. It usually happens during volatile market conditions or when liquidity is low, potentially impacting investor profits.

How to reduce Forex Trading Costs (Transaction Fees)?

1. Become a Large Trader:

Financial institutions aim to make money from servicing clients, so large traders often enjoy more favorable terms. Becoming a large trader can be achieved by either conducting substantial fund transactions or increasing trading frequency. In forex margin trading, financial institutions often offer smaller spreads to high-frequency traders.

2. Choose Suitable Trading Hours:

Similar to stock trading, forex trading during low-volume periods tends to have larger bid-ask spreads. To minimize spreads, avoid the following three time periods:

3. Pick Low Trading Volume Hours:
- For example, between 5 AM and 8 AM Hong Kong time when the three major forex markets (US, Europe, Tokyo) are still inactive.

- Around major economic indicators: During events like US Federal Reserve rate decisions or non-farm payroll data releases, currency volatility increases, leading to larger spreads.

- After significant events: Events like 9/11, major earthquakes, or war outbreaks cause substantial currency fluctuations and corresponding spread increases.

4. Select Suitable Currency Pairs:

More actively traded currency pairs tend to have smaller spreads because there are more counterparties in the market. Whether buying or selling, quick execution and prices closer to market rates are possible. Less liquid or less popular currencies are not conducive to investor trading.

5. Choose the Right Trading Platform:

The forex market is the largest and most liquid financial market globally. Whether dealing with fiat or virtual currencies, volatility is significant. As an investor, enhance your investment knowledge, understand different currency and commodity trading methods, and choose a suitable trading platform. This tool can serve as a hedging or asset appreciation instrument, helping you achieve financial freedom sooner.

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