Forex markets always include something known as the spread between two currencies. The definition of the spread is the difference between what a buyer is willing to pay for the currency pair, and what a seller is willing to sell it for. Obviously, the selling price will always be a little bit higher than the buy price. The separation that the two have is what is known as the spread. Other terms for the buying price and the selling price are the Ask (selling price) and the Bid (buying price).
When a trader looks at the bid and the ask on any specific currency, what they are seeing is what people are legitimately offering to pay for the currencies at this time. They are seeing what the price is if they should decide to get in on the action themselves. If they are eager to make a purchase, then they can agree to meet the seller at the asking price and just go ahead and place the trade. Likewise, if they are looking to sell the currency pair, they are more than welcome to meet the buyer at the bid price and go ahead and sell. Either scenario is how trades are made and how new prices are created in the Forex market.
How Brokers Make Their Money
You might have already come across some information telling you that Forex does not involve any commissions on the trades. You may have raised a skeptical eyebrow and wondered to yourself how any broker could possibly stay in business if they aren’t charging commissions on the trade. It is commendable that you have thought this far ahead about the process, and it goes to show that you are already working away on the exact mindset that you need to have to be a talented trader. To answer the question of how brokers make their money though, look no farther than the spread between currencies.
The brokers are making their money on the difference between those currencies at any given time. When you want to buy or sell your currency, they are able to perform the opposite action on the other side of the same currency pair at the lower or higher based on what is advantageous to them at that time. You have to start a little in the red on your trade when it first opens because you have had to deal with the spread between the pairs. It is not the end of the world that you find yourself a little behind on the trade in the beginning. This is actually just the way the market works, and you should accept that this is part of the risk of trading.
How To Measure the Spread
Generally speaking, the spread between two currencies is measured in pips. You may see a price on the EUR/USD quoted as something like this: Bid: 1.1000 Ask: 1.1002. In this scenario, the spread between the two quoted prices is a full 2 pips. This means that no matter if you buy or sell the currency, you will start 2 pips in the hole on your trade
You can’t make money in the Forex market at all unless you are in some trades, so you do have to suck it up and accept the fact that you will have to pay spreads at some point. This may make you ask yourself twice exactly what you can do to reduce your risk when you enter a trade.
It might be obvious to you at this point that you need to look at currency pairs that have the tightest spreads between them to avoid as much of the risk as you possibly can when trading. A pair like the EUR/USD does tend to have some of the tightest spreads (often less than 1 pip) as it is one of the most heavily traded currency pairs on the market. Additionally, you should check with various brokers to see which are offering the best spreads on all of the currency pairs up for trade. You see, some brokers offer better terms on spreads than others, and it is worth doing some comparison shopping before deciding on any given broker. The spread is a big deal in terms of your ability to make money in Forex trading in the long run.
Fixed Or Variable Spreads
Most brokers offer fixed spreads at this time, but it is worth noting that some still offer what is known as a variable spread. If your broker also operates as a market-maker, then they will offer a fixed spread on the currencies. That said, non-market-maker brokers may offer a variable spread that floats with the conditions of the market. A variable spread can be riskier for the simple fact that the variable terms may not work out in your favor in the ways that you would hope they would. They might provide tighter spreads at times, but it is also possible that the spreads will widen and cause you to pay more for the currency pair than you would have with a fixed spread provider.
Advantages of Fixed Spreads
There are many advantages to trading with fixed spreads. The biggest advantage that they provide is the fact that they don’t require as much upfront capital to trade. Many Forex investors have just a small amount of money to dedicate to the Forex markets. They want to get this money to work in the markets for them, but they don’t necessarily have the large accounts that some of the institutional players throw around. Thus, the smaller investor should look at a broker that can offer fixed spreads to them so they can get their money to work in the market as well.
Another big advantage to using fixed spreads in trading is the fact that you always know what spread you will have to deal with in a given pair. You don’t have the option to trade in a different spread, and that means you don’t get the chance to potentially benefit from a tighter than usual spread, but you also avoid the risk of market conditions making the spreads wider than they normally would be. Basically, you can plan out your trading strategy much more easily when you have a fixed spread that you know you will need to pay.
Disadvantages of Fixed Spreads
It can’t all be good news and upsides, can it? There are some disadvantages to fixed spreads as well. One of the most frequent (and most annoying) disadvantages for those trading with a broker that offers fixed spreads is that they may be re-quoted on their trades often.
A requote happens when market conditions get volatile and the broker is unable to honor the original quote that it offered to the trader. They are offering a fixed spread, but it is possible that the currency pair will move well beyond the price that it had quoted to the investor at the time. The broker cannot simply accept offering this lower or higher price when it is dramatically different from what the market conditions are at that time. Instead, they must offer a re-quote to their customer. This is when they offer the currency pair at the new price that it is trading at now. An investor may miss out on their trade entirely because they do not want to accept the new higher or lower quote that they are offered when they are re-quoted on it.
Advantages of Variable Spreads
Variable spreads are risky as we have already mentioned, but there are some upsides to them as well. At some points of high liquidity, it is possible to get very tight spreads on currencies that you want to trade. Imagine trading in a currency pair and only seeing a one-half pip spread or even less! That is almost like conducting your trading business with zero cost to you on the trade. Indeed, this is a major upside to variable spreads as they sometimes offer amazing opportunities like this when market conditions are right.
Disadvantages of Variable Spreads
There are a lot of disadvantages of variable spreads as well. You can find yourself at a major disadvantage on pricing when the spreads rapidly widen on the trade you wanted to make. Perhaps you enter into a trade when it has just a 1.5 pip spread, but then it suddenly jumps to a 5-pip spread, and you might be stuck with the trade anyway! That can put you way behind on your money from the moment the trade is opened, and that makes it very difficult to become profitable on that trade.