Brokers use Overnight
Recently, I found a stimulating trading strategy, intended for futures trading but theoretically applicable to retail Forex trading. The strategy’s author claims that even with completely objective and easy rules, an easy and complete “trend-following” strategy traded across a widely diversified group of liquid futures markets has produced a mean annual return of roughly 20% per annum over the past 20 years , significantly outperforming global stock markets and equating to the type of returns produced by professionally managed trend-following managed futures hedge funds.
As a Forex professional, I took a better check out the strategy to ascertain what quite edge it’d have historically provided to retail Forex traders. The results make interesting reading because they illustrate exactly why it are often so difficult for retail traders to take advantage of edges that exist within markets.
For the sake of full disclosure I reproduce the strategy rules in full:
Risk: the 100 day ATR (Average True Range) should equal 1 unit of risk.
Entry: long at the top of any day which closes above the very best close of the previous 50 days; short at the top of any day which closes below rock bottom close of the previous 50 days.
Entry Filter: long entries only the 50 day SMA (Simple Moving Average) is above the 100 day SMA; short entries only the 50 day SMA is below the 100 day SMA.
Exit: A trailing stop should be used of three times the 100 day ATR from the very best price since the trade was opened (for longs), or rock bottom price since the trade was opened (for shorts). The trailing stop must be recalculated constantly as a “chandelier stop” and it should be a soft stop: an exit is merely made when a daily close is at or beyond the stop loss.
This strategy was tested against the foremost liquid and popular spot Forex currency pair, the EUR/USD, over an extended and up to date period of your time (from September 2001 to the top of 2013), using publicly available spot EUR/USD data with the daily open and shut in the dark GMT.
The results show that the strategy provided a winning edge on EUR/USD during the trial period . Over 366 trades, a complete return of 33.85 units of risk was achieved, giving a mean positive expectancy per trade of 9.25%. this suggests that the typical trade produced a return adequate to the quantity risked plus an additional 9.25% of that quantity . Considering the strategy is totally mechanical, which it represents just one instrument within what’s traditionally the worst-performing trend-following asset class (currency pairs), this is often not such a nasty result.
However, fees and commissions must be factored in, to work out the return that would even have been enjoyed. Assuming that:
the trading was performed by a fund with EUR/USD futures contracts, and
a quarter of the trades had to be “rolled over” before the contract expired, incurring a further commission, and
a “round trip” commission of $20 per trade had to be paid, and
an account of $10 million was traded with each unit of risk equaling a hard and fast 1% of the starting asset size, then
the total return would equal $3,385,000 minus 366 trades multiplied by $25 each, representing the commissions. this is able to mean a discount of the return by only about 0.1%, giving a complete return of 33.75%. It might be assumed that if the rolling over strategies were but perfect, there would be some additional losses.
Imagine now a retail trader with an account of $10,000 who wants to trade this strategy employing a retail Forex brokerage. Luckily for this trader, the brokerage allows access to some quite approximation of a derivative instrument which will be traded with a really small lot size, also as very small lot size spot Forex trading, so there’s no problem with scalability.
The next step is to figure out some likely costs of trading for the retail trader trying to implement this strategy over an equivalent period on the EUR/USD. First of all we will check out the value of using spot Forex:
Each trade incurs a selection of two .5 pips, and
Each position that is still open at the ny close incurs an overnight swap charge that varies from position to position, but which averages bent , let’s say, three-quarters of a pip per night.
For the sake of simplicity we will perform a rough calculation based upon pips. The 33.85% return calculation was based upon a profit of 9,088 pips. The spread alone is 2.5 pips multiplied by the 336 trades, which are adequate to 840 pips. Next, we must deduct the overnight swap charges. Our retail trader had an edge open over 9,889 nights, which might account for 7,417 pips. So we must deduct a complete of 8,257 pips from our total profit of 9,088 pips, which leaves a net income of only 831 pips!
For the sake of this rough calculation, if we assume that the return is evenly cover each pip, this represents a greatly reduced net income to our retail trader of only 3.09%, as against the 33.85% return achieved by the $10 million fund we checked out previously.
Our retail trader may need an alternate , which might be to shop for synthetic mini futures contracts which don’t incur overnight swap charges, but which have much wider spreads; something like 14 pips per trade for EUR/USD. Taking another check out the numbers and also assuming that one quarter of all trades must be rolled over, our retail trader would face a fee of 14 pips 458 times, equaling a deduction of 6,412 pips. this is able to represent a net income of two ,676 pips. Assuming again that each one return is spread equally over each pip, our retail trader ends with a net total return of 9.97%. So using synthetic mini-futures would are far more profitable, but would still represent an annualized return over the trial period of but 1% profit per year! Furthermore, this return would be but one third of the quantity enjoyed by the massive fund.
Breaking it down
Why are things so bleak for our retail trader? There are several reasons, and examining each reason carefully can help any aspiring retail trader understand how certain edges within the market are often effectively whittled away by the incorrect choice of brokerage or execution methods.
Actual futures contracts are overlarge to be available to most retail traders, and position sizing can’t be achieved properly with amounts but several million dollars during a diversified trend following strategy. Mini-futures are a possible solution, but if they’re not very liquid then they’re unlikely to present an equivalent trend-following edge as ordinary futures. Exchange Traded Funds are another partial solution, but however , the retail trader goes to possess to pay some quite spread for access to an appropriate market far in more than the $20 trip commission payable by a large client of a futures market .
This brings us to the subject of spreads. Frankly, there’s no reason whatsoever why even a retail trader should be paying quite 1 pip for a trip trade on an instrument as vanilla because the spot EUR/USD. Brokers charging quite this really haven’t any valid excuse. It should be said that spreads within the retail sector are taking place in recent years. While this is often excellent news , albeit the retail trader in our example had been paying 1 pip rather than 2.5 pips, this is able to have raised profitability only by a further 1.5%, and can’t truly be backdated all the thanks to 2001 in any case.
This brings us, finally, to the important culprit of the reduced return: the overnight swap rate, which is widely misunderstood, then is worth an in depth examination.
Overnight Swap Charges
When you make a Forex trade, you’re effectively borrowing one currency to exchange for an additional . you want to therefore logically pay interest on the currency you’re borrowing, while receiving reciprocally interest on the currency you’re holding reciprocally . there’s usually an rate of interest differential between the 2 currencies, which suggests you ought to either be receiving or paying some extra fee each night representing the differential, and in fact the rate of exchange may be a factor as currencies rarely trade at 1 to 1. the sole time there would be nothing to pay or receive would be if the exchange rates were exactly equal at the rollover point, and there was no rate of interest differential.
It would seem that sometimes you pay the difference and sometimes you receive it, so overall this swap cancels itself out. Unfortunately it’s not as simple as that, for several reasons:
Currencies with higher interest rates tend to rise against currencies with lower interest rates, so you tend to seek out yourself in additional long trades over time where you’re borrowing the currency with the upper rate of interest, meaning you tend to be paying more often than receiving.
Retail Forex brokers charge or pay quite wildly different rates to their clients long or in need of a specific pair. Many brokers are very opaque about this and don’t even display the applicable rates on their websites, although the rates are often found within the brokerage prey on every MT4 platform. it’s worth mentioning that, to be fair, there are legitimately different methods of calculating this charge. However if you check out the table compiled at myfxbook showing a variety of overnight rates charged by some retail Forex brokers, you’ll get a way of the big variety within the market.
In addition to charging or paying the rate of interest differential, some brokers also add an “administration” fee, which may mean that you simply won’t receive anything even when the rate of interest differential is positive in your favor! Ironically, these tend to be an equivalent brokers which will bill you for account inactivity, and exactly what administration is involved when the trades are rarely even booked within the real market is very questionable. the top result’s to skew the fee even further against the client.
Most traders are highly leveraged, which suggests that they’re borrowing the overwhelming majority of the currency they’re trading. Traders tend to forget that one among the negative consequences of leverage is to push up the overnight swap charges, as they need to pay interest on all the borrowed money, and not just the margin that they’re putting abreast of the actual trade. Of course, this is often a legitimate element of the charge.
The practice of charging a fee for each night a client keeps an edge open isn’t only hospitable abuse, but are often an efficient thanks to dramatically reduce the chances that a trader might seek to maneuver in their favor by an intelligent use of long-term trend trading, which usually pays off over time if executed properly. it’d be said that some retail brokerages are using the widespread ignorance about these charges as how to feature to their balance sheets, which regulatory agencies should be taking steps against this. On the opposite hand, it could even be said that a market maker can’t be expected to form a market during a way where they will be systematically put out of pocket by the long-term statistical behavior of the market. it’d be that a lot of of the differential rates between brokers are reflected by the currencies that their clients are long or in need of at any particular time. It are often seen that one broker could be offering a far better deal than another on one currency pair, but not on another, which seems strange.