Understanding Spreads In Forex

In the forex market, a spread is the difference in pips between the BID price and the ASK price quote (buy/sell) in a currency pair such as the EUR/USD. A spread is also the easiest way for many brokers to get compensated for each transaction the customer makes through their trading platforms. This is the simplest way to understand what a spread is: EUR/USD is priced at 1.1500 the broker will offer it for 1.1501 to buy or sell at 1.1499.

The trading price for any currency pair is expressed by the combination of the symbols that make up the currency pair as well as the bid and ask price. It’s expressed as follows:

Base Currency/Currency trading | Bid Price/Ask Price

If at any point the quote for the euro against the US dollar is 1.1500 – 1.1502 it reads as follows:

EUR/USD = 1.1500/1.1502

The BID is the highest the trader is willing to buy, also known as purchase price or demand. It is the price at which the trader will enter the market when selling the currency pair. The Ask is the minimum price you are willing to sell, also known as selling price or supply. It is the price which the trader will enter the market when buying the currency pair.

The difference between BID and ASK is best known as the spread. The spread is expressed as pips or points. In this example, the spread in the EUR/USD is 2 pips or points.

Cost for each transaction

The spread is the cost of each transaction performed by the trader in the market (not including any other fees such as swap or commission). This cost can vary from broker to broker. There are brokers that use the market maker and ECN system which allows them to charge a very tight spread but charge commission for every transaction executed. The spread is the basic compensation for each broker and other third parties if applicable. These third parties are introducing brokers and/or money managers, who can also get compensated for their services through the spread.

How does the spread work?

Let’s follow this example: Trader X wants to open a buy position in EUR/USD at a price of 1.2001. Immediately, the broker executes the order and most likely executed the order at 1.1999, instantly making 1 pip on the execution. Now trader X wants to close the buying position and sell at 1.2010, but then the broker will most likely execute the order at 1.2011 to make another pip on the execution.

In the example above, the trader encounters a fee for every execution in order to trade the forex market, in order to obtain profits from every transaction. The expectation from each trade should be over the spread amount to capitalize on every trade. In each currency pair the cost of spread is different and also the trader should account for those variables in order to make more money than the actual spread cost.

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