Introduction to Forex spreads on the Forex market
Transaction costs are charged on the Forex market whenever a new position is opened. This transaction cost is called the “spread” which means the difference between the Bid and Ask prices of a currency pair. To know how Forex brokers obtain their spreads and what Bid and Ask prices are, you first need to know how currency pairs are quoted in Forex.
Currencies on the Forex market are always traded in pairs. A currency pair comprises the base currency (left side of pair) and the counter/ quote currency (right side of pair). Quote of a currency pair tells how many units of the counter currency you can possibly buy with one unit of the base currency. Let’s put this in plain words by looking at a typical example of a Forex pair.
The EUR/USD pair trades at 1.1845. In this illustration, the euro (EUR) stands for the base currency, and the US dollar (USD) refers to the counter/quote currency. What this rate means is that 1 euro will cost you 1.1845 USD.
Forex traders endeavor to predict the future price movements of currency pairs with the aim of making a profit. If a trader feels that the rate will rise, he will buy the pair. And if he believes the rate will drop, he will sell the pair. An upswing in the currency rate signifies that the base currency is rising in value, and the counter currency is falling in value.
How currency spreads are calculated
Bid rate and Ask rate are the two rates always available for a given currency pair. The Bid rate is the price your broker is prepared to buy the base currency from you, and the Ask rate is the price they’re ready to sell the base currency to you.
The difference between the Bid and Ask rates is known as the “spread”, which represents your broker’s profit. The broker buys the base currency at a lower price (Bid rate), and sell later at a higher price (Ask rate), which is why Ask rate is higher than Bid rate.
Let’s include the Bid/Ask information to our EUR/USD pair example again and expand it on the table below.
Pair Bid Ask
EUR/USD 1.1845 1.1847
The EUR/USD rate of 1.1845 stands for the Bid rate, i.e. the price in dollar terms the broker is ready to buy 1 euro. The Ask rate of 1.1847 is the price the broker is prepared to sell 1 euro. This signifies a spread of 2 pips. Whenever a position is opened, you will ultimately have to close the position, thus paying the spread to your broker.
The spread cost depends on the size of the position you wish to open. While the pip value of a 1k position size is about 0.1 USD, the pip value of a standard lot (100k) position is nearer to 10 USD. Opening a 10k position on EUR/USD with a 1 USD pip value would invite a 2 USD spread cost on the transaction.
However, Forex transaction cost is one of the lowest compared to other major financial markets. The cost of opening a position on the Forex market is generally only the spread that your broker charges. Conversely, cross currencies that don’t concern the US dollar can have considerably larger spreads which is why traders should take Forex spreads into account when building their trading strategy.
Types of Forex spreads
There are a number of them used on the Forex market but the following types are most common:
- Fixed spreads:- These spreads are unvarying and are not dependent on market conditions.
- Fixed spreads with extension:- These spreads have a fixed part and a variable part which the broker can adjust in line with existing market conditions.
- Variable spreads:- These spreads completely embody the current market condition and the pair’s liquidity. In normal market conditions, variable spreads can become very tight but with increased market uncertainty and during major news releases, those spreads can get as high as 40 to 50 pips.