For a better understanding of the spread and the effects, it has on must understand the basic structure of forex trades in general. You can generalize the trade structure to all trades are via a middleman who charges for his services. Just like a majority of financial markets, you will typically see three prices, the buy price, the sale price, and the market price. The difference between the sell and buys prices is known as the spread.
A spread in forex is primarily defined as the difference in prices where traders may buy or sell a particular asset. It is a very basic concept; however, you will come across it frequently as you are trading financial markets. It may also significantly affect your trades profitability. For example, let's say that you open a position with the US dollar as the base currency. Seeing as there is no demand deficiency for the dollar- the forex-spread for this particular transaction will practically always be less than that of a less popular currency.
The main reason is supply and demand. Brokers will name have any problems at all in selling off the US dollars they purchased. Therefore there is no reason for them to charge you as a trader a greater spread. On the other hand, if the base currency of the position was the Vietnamese Dong, for example, they are likely to be higher. This ultimately means that the broker has taken a more significant risk, and therefore has to charge more for this risk. For this reason, I suggest that as an individual trader, avoid purchasing and selling low demand currencies. As it will be more costly.
Seeing as we have understood that no matter how attractive forex trading is, it is not entirely free. Now we must also realize what differentiates stock market commission
and forex spread. The main difference is – in forex you are only charged a spread on the buy side of the transaction. Brokers generally make a profit from charging you a spread when you buy a currency.
How does Forex Spread work exactly?
If a broker buys and sells a currency without any change in the exchange rate, the person who would lose money is the trader. The trader would lose because the selling price is often always more than the buying price. Meaning that the broker will always profit from the transaction. A more familiar example is when you are traveling, and you exchange your money in a foreign bank. You will notice that every time they will offer more when buying your dollars than when selling them to you.
Another factor that brokers consider is the kind of account you are using to trade. Small accounts are usually those that have higher spreads. This is because to make up for the low capital that is being traded; there needs to be higher-spread for the broker to make a profit.
There are several charts available online that allow you to compare forex spread. You get to see where brokerages lie in comparison to each other, with each currency having a different spread.
Who sets it?
The spread is determined by other market participants when it comes to trading assets such as shares commodities or forex, If you trade at the market price, the least price you can buy it at is the offer, and then sell it at the highest price which is the bid.
Regarding trading derivatives such as spread betting
or CFDs, your provider usually adds their spread on to the market price. This particular spread is the fee you pay for trading this derivative.
What are the effects?
Apart from pricing, there are a couple of factors that impact its size;
- Generally, the more people buy and sell a specific market, the more its spreads become tighter. The lesser the participants, the wider the spreads.
- Volatility like that which occurs as a result of economic announcements or significant news may cause significant market movements which increases the spreads.
Why is it important?
Tighter spreads typically mean less trading costs, that is if all else is constant. Reason being that tighter-spread results in the market price not having to move so far from the entry price for you to get a profit. As a trader, the spread is far more imperative to you than to the broker. It is your “fee of doing business”. The more regularly you trade, the more important the size of your trade is to your ultimate profitability.
It is imperative for traders to understand how important the spread is when it comes to choosing a broker. The difference that a single forex pip makes in brokers spread may be what separates a successful forex trader from a complete forex failure. ( a pip is the fourth digit that comes after the decimal.)