Understanding Forex Trading Spreads and Investment Costs

Novices considering currency trading will read that Forex brokers charge no commissions and cheer. But don’t be fooled. Whether anything in life is truly free may be up for debate, but one thing is certain: nothing in investing is.

Forex market makers and brokers make money from something called ‘the spread’. It’s important you understand how it works.

Suppose a trader is dealing directly with a market maker. A market maker is an individual or company that directly offers a currency pair trade, as distinguished from a broker who acts as an intermediary. The bid price is that which the market maker offers to BUY the base currency from the trader. The ask price is that which the market maker requires in order to SELL the base currency in exchange for the quote currency.

For example

EUR/USD 1.1900/05 means

If you buy 1 EUR you will pay 1.1905 USD
If you sell 1 EUR you will receive 1.1900 USD

The difference between those two prices is called the SPREAD and it is how market makers (and, indirectly, Forex brokers) make a profit, in stead of charging commissions. In practice, for every seller there must be a buyer for any trade to take place. The broker, acting as an intermediary – unless he or she is also a market maker buying and selling for his or her own account – locates a trading partner.

If you are willing to sell euros at the exchange rate of $1.1900 the broker locates someone willing to buy them at $1.1905. The broker pockets the difference, in stead of receiving an explicit commission.

How does this affect you, the Forex trader? You are paying for the spread, in essence.

Suppose you were to accept the trade and sell euros for dollars. The bid price will apply so you receive 1.1900 dollars for every euro sold. Now suppose you wanted to immediately buy those euros back from your broker. The ask price will apply so you would pay a rate of 1.1905 dollars for every euro acquired. That difference, the spread, is measured in points or pips, in this case 5 pips.

That five point difference would result in an immediate loss to you, even though the exchange rate hasn’t changed by a single pip. You sold euros for 5 pips less ($1.1900) than you bought them for ($1.1905).

Calculated in terms of dollars rather than points, you would lose $5,000 on an immediate trade of 100 lots. $11,905,000 – $11,900,000 = $5,000. At 1/250th leverage, however, this equates to an actual ‘commission’ cost of $5,000/250 = $20.

It’s perfectly legal and ethical. It’s simply the cost (to you) of trading in foreign currency.

As a result of the spread, which accompanies every quote, traders must wait for the market to move by at least that amount just to break even. To profit, the exchange rate must move by more than the spread. Of course, while you wait, the exchange rate can move in either direction and may result in an even greater loss if you liquidate your position.

In our example, you sold euros at 1.1900 and will have to see at least a 6 pip change in ask price (from 1.1905 to 1.1899) before you can buy euros at a profit. Every currency pair price – the exchange rate – moves, by definition and convention, a minimum of 1 pip. You will never see a 1.5 pip change, for example. This minimum is a one point change in the last digit in the price quote.

Of course, actual trading is not so simple. That needn’t be bad, though. That can work for you. Brokers or market makers offer different amounts and types of spread to different customers at different times.

Spreads may, and often are, narrower for those who have a 100K account and larger for those with a mini account. You put more money into the game and you get a better deal. That’s reasonable and normal.

Spreads for a mini account may be as high as 10 to 15 pips, and as low as 5 pips or less for a 100K account. Large banks and institutional traders are typically the only ones to receive ultra-low spreads.

Also, many brokers differ in the terms under which they’ll offer variable versus fixed spreads. For example, a broker might offer a variable, and decreasing, spread as the notional amount of the trade increases.

As an example, you offer to buy 10 standard lots of euros (10 x 100,000 euros x 1.1905 $/euro = $1,190,500) and the spread is, say, 3 pips. If the deal were only for 1 standard lot (100,000 units) the spread might be 5 pips.

Note that because Forex trading is highly leveraged a trader may only have to input 1/250th of the actual amount of dollars. Even that low fraction still amounts to an investment of $4,762 ($1,190,500/250) for 10 standard lots. Though high, that amount is within the reach of many non-professional traders.

Spreads can differ due to a dozen different circumstances. Just as with bonds, mortgage lending and every other form of investing today, the variations are many. Spreads will differ from broker to broker and from trade to trade. They can depend (as we’ve seen) on the amount traded, the established relationship between broker and client, or recent volatility, or current liquidity… The list is endless.

As a result of this, it pays the trader to do some homework and shop around for brokers that offer their clients the best spreads, on average. But beware – cheaper is not always better. Fixed spreads are typically slightly higher than variable, but offer the insurance of locking in a known cost.

It does little good to get great (super-small) spreads if your broker’s execution times are typically bad or if trades are frequently rejected. You want trades made quickly so they can be made as close as possible to the up-to-the-minute price you saw on your screen. You also want a broker who will be honest and ethical and not employ any of the many tricks of the trade for increasing their profits at your expense.

If you make the effort, you will find a broker or market maker who offers honest deals at reasonable spreads. Despite the huge volume of Forex trading (in the neighborhood of a few trillions daily worldwide among thousands of banks), it is still in some ways a small world. Word gets around and a bad reputation can ruin a broker.

Make sure you read the fine print and execute enough demo and small dollar volume trades to get used to Forex trading and how spreads affect your profits and losses. Forex trading is much more complex, volatile and fast-paced than even typical day trading in stocks. An educated investor will suffer fewer avoidable losses.