## Sunday, March 21, 2010

### Transaction costs : forex vs stocks

I've decided to take a quick look at the transaction costs involved in forex versus stock trading. Most of the forex brokers brag about 'no transaction costs', but the impact of the ask-bid spread is often unclear. The results were  as expected: forex has higher transaction costs than the stock market. .
To enable the comparison of the costs I've defined a cost_ratio=spread/(max(bid)-min(bid)); . In other words, the cost ratio is the transaction cost divided by the price range in some given period of time. I am using a week. To calculate the cost ratio for forex I've taken the spreads for 'USD/CAD'    'USD/CHF'    'USD/DKK'    'USD/NOK'    'USD/SEK' pairs relative to their weekly range and then averaged them. (data source: Gain Capital)

The cost ratio for a stock is calculated in a similar way. SPY has a weekly range of about 2% (rough estimate) , one share price is around  \$115, so the weekly range is 0.02*115 = \$2.3. Transaction costs at IB are \$0.005 a share, resulting in a cost ratio of  2.2e-3.

The results are in the graph below:

The cost ratio for forex seemst to be around 5 times higher than for stocks. This changes of course if a lower priced stock is traded. For a \$20 share with the same weekly range , the price ratios between forex and stock market are roughly equeal.

I guess the difference in cost ratios is the price you pay for liquidity, minimal slippage and real-time data.

1. Interesting analysis but don't forget swap for overnight positions in currency markets. Also triple swap on Wednesday. Also FOREX is an OTC market and you have to be very careful who you choose to trade through.

I enjoy reading your blog and have recently started using Matlab in my research process.

2. how does only USD/EUR compare with SPY? I believe this is more of a like-with-like comparison, than including NOK or SEK

3. @ anonymous: Good point. I've noticed that most of the spreads seem to have a comparable cost ratio, something between 0.005 en 0.015. USD/EUR should be no different.

4. The main reasons for the difference in transaction cost are:

- FX is a forward contract with credit risk (an agreement to exchange ccys n days forward). To participate directly on the FX venues one needs to have counterparty / credit agreements with all participants you might trade with. For this reason major venues such as EBS only show you prices for the set of counterparties you can transact with.

Hence short of being a big bank, one cannot participate directly on FX venues. The second level up is prime brokerage, allowing one to trade directly on venues but with the prime broker as the counterparty. The independent trader or small fund is forced to deal through brokers such as IB. IB adds on a premium through their market making (i.e., their best bid/offer is not the "market"'s.

- The usual minimum trade size with any liquidity on the FX venues is \$1m (or equiv in ccy). Trading smaller sizes requires a market maker intermediary willing to take on the risk of accumulating position in tradeable amounts.

With the equity market one can trade in small sizes (say 100 shares) and interact directly. There are also regulations on providing "best execution", unlike the FX market. The equity market is much ahead of other markets for algo trading.

5. IB is not a market maker in spot fx...

6. I appreciate your efforts to put some decent tools in the hands of traders -
I believe that the blog will make better,
more disciplined and less driven traders with the possibility of actually making money; priceless!