Defining a forex spread
A spread is an essential element in forex trading, and every trader must understand how it works. It involved two prices that we call the bid price and ask price. A forex broker will give you a quote about these two separately for a currency pair. When we say bid price, we refer to a price that one can sell the base currency. The ask price refers to the price to purchase the base currency. If we subtract these two, the difference is what we call the spread. A spread is also known as the bid-ask spread.
Tell me more about the forex spread!
Sometimes, the forex broker earns through a bid-ask spread by putting markup in the buy and sell price of the currency pair that a trader prefers. We can use any other business as an analogy with the way forex brokers earn money. The forex broker makes money by providing his products or services.
Let us think about the currency pair that you want to buy as their product. The forex broker makes money by selling this currency pair by selling it more than the amount that they paid for it. In another scenario, let us assume that you are the one selling the currency pair. They will buy it from you at $10, but they sell it later on for $12. If we subtract $10 and $12, the difference will be $2, and $2 is what we call the spread in this scenario.
So, if you are too new in trading, you might fall into a forex broker’s sweet words saying that they charge no commissions because, for most circumstances, it is simply not true since they make money by the spread. It is a misleading idea because even when it is true that there is no separate commission fee, you still technically pay, and it is already together in the bid-ask spread.
How does one measure a forex spread?
One can measure a forex spread by using pips. The smallest possible unit of a currency pair’s price movement is teh pip. Usually, a currency pair’s one pip is equal to 0.0001. It holds the fourth place to the left of the decimal point. Only the Japanese Yen’s pip is placed two decimal places after the decimal point (0.01). The pip also moves on the third place after the decimal point if there is a fractional pip.
For example, a change of one pip in a EUR/ USD pair is 1.1234/ 1.1235. Let us break down all the elements:
- Base currency = EUR
- Quote currency = USD
- Bid price = 1.1234
- Ask price = 1.1235
- Spread: 1.1235 – 1.1234 = 0.0001 (spread of 1 pip)
- Pip = 1 change of a pip
Let us also cite an example of a Japanese Yen pip where the currency pair USD/ JPY is at 110.00/ 110.02.
- Base currency = USD
- Quote currency = JPY
- Bid price = 11.00
- Ask price = 11.02
- Spread: 11.02 – 11.00 = 0.02 (spread of 2 pips)
- Pip = 2 change of pips
To cap it off
A forex broker’s spread may be different from another forex broker. Forex brokers from other trading platforms have different ways and styles on the way they earn their money.