In the Foreign exchange Market or FOREX Market is important to know some definitions and concepts that are fundamental to its process. Let’s start step by step, and let me tell you what I am talking about when I say “spreads”. The difference in pips between the BID price and the asking price quote (also called buy/sell) in a currency pair like the USD/EUR in the FOREX trade is called Spread.
But, what is a pip?
There is a unit of measurement to express the change in value between one currency and another in the FOREX market and that is what is called a Pip or “Price Interest Point”. It is translated as the smallest price move that can be given in an exchange rate. And, usually, is the last decimal place of quotation. So, how does it work? Well, traders often use the pips just to reference gains or losses.
What are spreads?
Spreads are the way for a lot of brokers to get compensated for each one of the transactions that are made for the customer through their trading platforms. So, the spread is nothing more than the cost of each one of the transactions performed by the trader in the market; of course, the cost can vary from one broker to another. A pip is defined as the fourth digit after the decimal. To know the importance of spreads, it is necessary to understand that the asking price will always be higher than the bid price and that difference is banked by the broker, obviously, as a profit. That is why the spread has such a significant impact on your work as a FOREX trader. Also, it doesn’t matter where is the spread at any given time, because it characterizes the cost that would be suffered to open and close a position in that instrument, at that moment, by marking-to-the-market (MTM) the trade at the moment it is established (even if the spread changes at the next moment).
Types of spreads.
- Variable spread: it changes in correlation with the market conditions. This type of spread is generally low in times of market inactivity; but, during high-volatility seasons, this spread can expand to 40 or 50 pips (keep in mind that, when there is market inactivity, the spreads are around 1 or 2 pips).
- Fixed spread: this is set by some dealings companies for automatically traded accounts. The spreads don’t vary.
Commissions and spreads
These are two concepts that can be confused. Commissions are either fixed dollar amounts or percentage of trade values. These are added to trades that are established when there is an opening or a closing position. Some firms are only charge spreads and others only charge commissions; and, in some cases, firms may charge both, the overall sum of charges should be noted. Now, it is evident that the two principal costs of trading are spreads and commissions, and this trader should establish from their broker what the spreads are if some tradable instrument offered by their firm. The commissions are also an important part of the broker and the trader. Now, what is the importance of spreads? Well, it’s really easy, the spreads maintain the broker because that is the money that the broker wins. Let's say we had a USD bid price of 1.2000 (the price at which the broker is willing to BUY the USD) and an ask price of 1.2007 (that is the price at which the broker is willing to SELL the USD). In that case, the spread is equal to 0.0007, $0.0007, or 7 pips, and that is the money that goes straight into the broker's pockets. That is the money that the broker wins. It is crucial to know that in the foreign exchange market is all about the supply and demand, just like any other market. Because, if there is a higher demand for dollars, the value of the dollar will naturally go up in comparison to other currencies. This is exactly how FOREX spreads are calculated. Another thing to have in mind is that what FOREX brokers take into account when calculating spreads is the type of account in which you are trading. That is because the Mini accounts are normally associated with the higher spreads. That is due to the broker’s needs to compensate the reasonably low amount of capital that is being traded with a higher spread so as to make any profit. It is tremendously important for you as a trader to understand that the spread is important at the moment that they are going to choose a broker. Because the difference one FOREX pip can make in a broker's spread might be the difference between a successful FOREX trade and a whole FOREX failure.