How Forex Spread works
One of the word you often hear in the finance, investment and market fields is definitely the term “Spread”.
This word doesn’t mean anything but “difference” or “differential”, but based on the scope in which it’s used, it assumes a lot of specific meanings. Let’s see what we usually mean when we talk of forex spread.
Forex Bid Ask Spread
We have seen how the value of the exchange rate between two currencies is expressed, however, when we approach a broker to ask him to buy or sell one currency in exchange for another, the broker doesn’t show us a single price, but rather two, one a little higher than the current value of the exchange, one a little lower.
These two values represent the demand and supply of that particular currency pair, or the Bid price and Ask price. So, let’s see how spread works.
The Bid price is always lower than the Ask price. To make things easier, let’s start from the Ask one.
– The Ask Price is the price you can find to your right in a classic book. Let’s suppose you want to buy the EUR/USD cross, that is you want to go LONG on that currency exchange.
You go to your broker and you ask him what is the price at which you can make this purchase. The broker looks at the listing, and says that on the market, at that time, the best seller, that is the one willing to sell you EUR/USD at the lowest therefore most convenient price (so to be SHORT on the same exchange) offers it at a price of 1.3001.
In other terms, he ASKs you 1.3001 for selling you the exchange, so your price to buy EUR/USD is 1.3001.
– Let’s pass to the the Bid price, that one you can find on your left in classic book. Let’s suppose on the contrary you wish to place an offer to sell EUR/USD, that is you want to go short on the currency pair.
The broker tells you that, to conclude the operation now, the best buyer, that is the one willing to buy at the higher price, would buy the EUR/USD at a price of 1.2999. So your price to sell EUR/USD is 1.2999.
The difference between your purchase price 1.3001, and your sales price 1.2999, which in this case is 2 pip, is called in jargon “spread”, which is the difference between the best seller and the best buyer.
The spread as the broker’s profit
To get their profits many brokers, of which the majority don’t operates in the Forex markets, take a small percentage of the volume of any transactions made by their customers.
For example, if the client opens a purchase transaction on Apple’s shares for a volume of $ 10,000, the broker will earn a small percentage of those $ 10,000, generally 0.05%, or 5 basis points.
Most of the Forex brokers instead do not charge commission like that, but they simply widen the spread of the market, perceiving this way their self-interest.
At this point we have created two types of spreads. There’s the real spread, based on the quoted market prices and its actual levels of supply and demand; and then there’s the broker spread, determined by the broker, who will take the real one from the market, will add a small amount in terms of pips, and finally will propose it to you for your operations.
The difference between the real spread and the broker’s one is precisely what the broker will gain from every client transaction. It means that the broker, for the fact of providing this trading service, asks you in exchange a small amount on the transaction you are about to carry out.
Taking the example above, if the market bid-ask quotes of EUR/USD were 1.2999 and 1.3001 respectively, the broker will place a further spread in both prices, for example 1 pip each, making you no longer see the previous values, but instead 1.2998 and 1.3002.
So you will see directly a price for the sale of 1.2998 and not 1.2999, and a price for the purchase of 1.3002, and not 1.3001. So, for you the bid and ask spread will be of 4 pips.
As said before, the Forex market is continuously evolving and it’s becoming even more efficient, and in addition to this, the competition among brokers is getting always more fierce.
What does it mean? It means that the additional spreads charged by the brokers are becoming smaller, for the benefit of the users’ and investors’ earnings.