Forex Spread : What Is It?

To make money with forex trading it is necessary for a trader to understand forex spread. This is the main cost that most traders will have, so it is important to understand how it is calculated and how much difference it can make to your profits.

Spread is the difference between the bid and ask prices of a currency pair, or the difference between the price given by a market maker if a trader wants to sell the currency pair (the bid price) and the price the trader must pay if he wants to buy the pair (the ask price).

This is how most brokers make their money. To see how it works, let us take a simple example.

Imagine that a trader is working with the currency pair EUR/USD. The ask price might be 1.4323 and the bid price 1.4320. If the trader wants to buy the pair, he will pay 1.4323. If he buys at that price and then sells with no change in the market, he will get 1.4320, 3 pips less. So the broker will have made 3 pips on the transaction.

Obviously this is a very important consideration for a trader because in order to begin making money on any trade, he has to first cover the cost of the spread. Spreads can be anything up to about 5 pips depending on the broker and the currency pair. This is a factor that needs to be taken into consideration when deciding on a trading system. The spread must always be allowed for when working out any system, especially if you are backtesting a system. It is easy then to forget it, but the spread can make a huge difference to the accumulated profits over time.

Not surprisingly, brokers will try to compete on spread and therefore the rates for the more popular currency pairs can be relatively advantageous. However, spread is not the only factor to consider when choosing a broker or analyzing your costs. Some brokers that have very low spreads have other ways of making money that must be taken into consideration.

In some cases there may be a fee per trade. This can be fine if you tend to make a low number of very profitable trades, but it is not so good if you make many small trades. In that case you would probably be better off with a broker who charged a slightly higher forex spread but no fee per trade.