Understanding the Forex Spread

Why the Forex Spread Is Known as the "Cost to Play"

What Is a Forex Spread?. Credit: forextrading.about.com

One way of looking at the general structure of any Forex trade is that all trades are conducted through middlemen who charge for their services. This charge, or the difference between the bidding price and the asking price for a trade, is called "the spread." To better understand the Forex spread and how it affects you, you must understand the general structure of any Forex trade. 

The Structure of a Forex Trade 

The Forex market has always differed from the New York Stock Exchange for which trading historically took place in a physical space.

The Forex market has always been virtual and functions more like the over-the-counter market for smaller stocks, where trades are facilitated by specialists called market-makers. The buyer may be in London and the seller may be in Tokyo. The specialist, one of several who facilitates a particular currency trade, may even be in a third city. His responsibilities are to assure an orderly flow of buy and sell orders for those currencies. This involves finding a seller for every buyer and vice versa. 

In practice, the specialist's work involves some degree of risk. It can happen, for example, that the specialist accepts a bid or buy order at a given price, but before he finds a seller, the currency's value increases. He is still responsible for filling the accepted buy order and may have to accept a sell order that is higher than the buy order he has committed to fill. In most cases, the change in value will be slight and he will still make a profit.

But as a result of accepting the risk of a loss and facilitating the trade, the market maker always retains a part of every trade. The portion he retains is the spread. 

An Example of a Typical Forex Trade and Spread

Every Forex trade involves two currencies called a "currency pair." In this example, we will use the British Pound (GBP) and the U.S. dollar (USD).

At a given time, GBP may be worth 1.1532 times USD. You may believe the GBP will rise against the dollar, so you buy at the asking price. But the asking price won't be exactly 1.1532; it'll be a little more, perhaps 1.1534, which is the price you will pay for the trade. Meanwhile, the seller on the other side of the trade won't receive the full 1.1532 either; he'll get a little less, perhaps 1.530. The difference between the bid and ask prices -- in this instance 0.0004 -- is the spread. That's what the specialist keeps for taking the risk and facilitating the trade.

The Significance of the Spread

Using our example above, the spread of 0.0004 British Pound (GBP) doesn't sound like much, but the larger the trade, even a small spread quickly adds up. Currency trades on the Forex typically involve larger amounts of money. As a retail trader, you may be trading only 10,000 GBP. But the average trade is much larger, around 1 million GBP. The 0.0004 spread in this average trade is 400 GBP, a more significant commission.

How Manage and Minimize the Spread

There are two things you can do to minimize the cost of these spreads:

  • Trade only during the most favorable trading hours, when many buyers and sellers are in the market. As the number of buyers and sellers for a given currency pair increases, competition for this business increases and market makers often narrow their spreads to capture it.
  • Avoid buying or selling thinly traded currencies. Multiple market makers compete for business when you trade popular currencies, such as the GBP/USD pair. If you trade a thinly traded currency pair, there may be only a few market makers to accept the trade and, reflecting the lessened competition, they will maintain a wider spread. 

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