What are spreads?
The Forex market is becoming one of the most popular markets for trading. Not only experiences traders, but also beginners are considering this market as an opportunity to maximize their income ever more frequently. Individual investors and traders are flocking to this market in order to trade just as they do with futures and stocks.
More and more individual traders are seeing more than a simple method to diversify their investment portfolio in Forex, and actually begin to consider it as one of the best and most lucrative component of their investment toolsets.
This is constantly happening, because Forex possesses a variety of advantages in comparison to other markets, stock, commodity or futures. Here are some of the things that you would commonly hear in FX commercials:
- Unprecedented liquidity. Forex is the largest financial market in the world at this moment. Everyday turnover is over 2 trillion US Dollars.
- Great potential for leverage. Private investors have access to a variety of leverage options reaching as high as 500:1.
- Lack of commissions (more on this later)
- Low trading expenditures
And yes, all of those are actually true.
As you may have noticed the last two points are all about expenditures related trading Forex, and this is exactly what we are going to talk about in this article.
Any trading activity of course entails certain expenditures, in Forex typically called spreads. It is quite important to know how they work, in order to be able to minimize the cost of trading.
Let’s begin with stocks, which is something that most traders are familiar with. While trading stocks, most investors have a trading account with a broker, and investment funds deposited in that account. The broker enters trades on behalf of the account holder, and of course, the broker receives some sort of compensation for such services.
While trading, the broker typically charges a commission for fulfillment of each trade. Brokers either charge a fixed commission for each trade, or a floating commission dependent on the size of your trade (more common).
What has to be noted, that these commission are usually charge on both sides of the trade – you pay them both when you and sell of stock. In Forex trading on other hand, most brokers do not charge any commissions whatsoever.
Of course, they do not provide their services free of charge. Being commercial companies, they also need to turn a profit.
Typically, what they do in order to achieve that is called “spreads”. In other words, this is the difference between the bid price and the ask price, formulated as spreads. The broker usually adds those spreads to the price of the trade, and this is considered your payment. Although this is definitely not a commission, it ultimately serves the same purpose. In a less straightforward way.
The good news though, are that such as spreads is only charge on one side of the trade. In other words, you do not pay spreads for exiting out of your position.
Therefore, spreads are the base cost of trading Forex, and you should pay special attention to what brokers offer in that regard.
The typically spreads can vary greatly between brokers. While the difference between trading with say, 4 and 5 pips spreads may seem to be insignificant, in reality it can grow very quickly, when you multiple it by the sum of your trades. Just think about it, 4 and 5 pips makes a 25% difference in your trading expenditures.
Another important thing that you need to know, is that spreads are based on the pairs that you trade, and the type of trading account that you have.
Most brokers offer different spreads for different currency pairs. The most popular pairs, such as EURUSD and GBPUSD typically have the lowest spreads. Less popular, exotic currency pairs though, are in less demand and feature much higher spreads.
Think about which currencies will be the best for you to trade, and make sure to apply potential spreads to your calculations.
Besides that, brokers may offer different spreads for different account types. For example, mini/micro accounts usually feature a larger average spread than more sizeable standard account types.
One of spreads peculiarities is that they are not “guaranteed” – being based on the frequently changing bid and ask prices. Most brokers will tell you that during time of high volatility, or extremely low trading volume, the spreads may widen significantly.
Such situations are rare enough, since due to Forex market’s massive nature causes of such issues can be predicted with relative ease. They do happen however, and you have to be wary of them.
Thus, we can definitively say, that spreads account for the most part of trading expenditures. The spreads can be very different from broker to broker, account types, and traded currencies. A small difference in spreads can account for thousands of dollars over several months.
All of this is why you have to make sure that you understand, which currency pairs you intend to trade, how often, and with which account type. Use all of those factors in the process of deciding which broker to choose, and look for the one that will offer the best and most suitable conditions!