Forex trading is more popular than ever. New traders do business in the market daily, and new brokerages are opening worldwide. People who once used to work 9 to 5 jobs are quitting their workplace to trade Forex. So, one may wonder what factors led to the overnight growth of the market? Two stand out, its simplicity and the potential for profit.
Before finding how spreads work, let us take a look at the Forex market. Investors register with a broker (the majority of them claim they charge no commission) and trade currencies. Some may ask how brokers make money if they ask no commission. They don’t help people make money out of the goodness of their hearts; they’re business people who they seek income. Brokers charge their clients what is called Forex spreads, so when choosing a broker, it’s essential to understand all costs related to trading with them.
The Forex market, like all the others, works on a simple principle, supply, and demand. If there is a high demand for a currency, its value will go higher than the one of the others. And this is how brokers define and calculate spreads. The difference between the bid and the ask price.
Traders know that the spread is a paramount factor in picking the currency pair they trade with, and even the brokerage they work with.
So why is it Forex spread important?
All traders must understand the concept behind the term “spread” because it can make a significant difference in the outcome of their actions. Brokers usually earn money via spreads. And traders should consider the spread as the price they pay for someone to facilitate their transaction. The brokers that offer no spreads or have tight spreads ask their clients to pay commission. But most brokerages nowadays don’t charge fees because they find it more beneficial to make a profit on spreads. However, there are some brokers (few) that ask for both commissions and spreads. So, traders need to check the conditions carefully they impose when registering with them.
From the perspective of the brokerage, they provide their clients with spreads to encourage them to make a profit without paying fees for each operation. Choosing this method makes them more appealing to the public because they can associate their name with the phrase commission-free.
From the traders’ perspective, it’s wise to consider both the spread and the facilities a broker offers to ensure that the benefits fit their needs. Some consider spreads an alternative to fees, but they don’t pay a flat rate. They need to calculate to determine how much they’ll pay in the end.
Let’s find out more about spreads
Another definition for spreads is telling us that a spread is a difference in price between what the brokers buy the currency from a trader and the rate at which they sell it. Let’s use an example to explain the process better.
You open a position in which the base currency is UK Pound, and there is a shortage in demand for it, so the spread is smaller than on the US dollar. Why? We come back to the principle that runs the market, supply, and demand. The broker will quickly sell the currencies they buy from you, so there is no reason to charge you a high spread. But if you would sell Thailand Baht, then the broker will ask for a higher spread because they expose themselves to risk. Brokerages always charge more for risky currencies. This is why it’s smart to trade popular currencies because exotic pairs will cost you more.
The rule of the thumb in the Forex world is that the more exotic the currency, the higher the spread. Beginner traders often pick the EUR/USD pair, even if it sounds thrilling to play with a pair like Norwegian Krone and Mexican Peso.
If the broker bought and sell currencies without the spread, the trader would lose money because they’d have to sell at a higher price than the actual bid. The transaction is similar to exchanging money at the bank when traveling. They usually offer more when they buy your money than when they sell the currencies. So, beginner traders should search for forex brokers with the lowest spreads if they want to register profit.
When calculating spreads, you should consider the type of account the brokerage provides. If you run a mini account, you’ll probably pay higher spreads. Why? The broker needs to compensate for the lack of funds your account has. With a mini account, you trade in tens of thousands of currency units. Seasoned traders place trades that get close to a million units.
What’s the difference between low and high spread?
The low spread is where the difference between the bid and ask prices when you place the trade is low.
The high spread is where the difference between the bid and ask price when you place the trade is high. This means that you start the operation in a significant loss. Traders always start businesses at a small loss unless they don’t collaborate with an ECN broker in periods when the spread is inverted. But these moments are sporadic.
We’ll use another example to explain this issue. You register with a broker that quotes the EUR/JPY pair at a bid price of 2.001 and the asking price of 2.000. You check the bid price because it’s the one at which you enter in the operation. If you start the trade now, it’s at a floating loss of 1 pip because the difference between prices is minus one pip.
You should always enter trades that have a profound difference between the bid and ask price because they allow you to invest in a better position. This is why you should always calculate the spread before making a move.
Hope this article provided you with the information you need to start your trades. Don’t forget to invest in your education when investing; it’s the only way to achieve your goals.