Forex Trading Spreads - What You Need To Know

Forex spreads hold ample control over how you trade and have a significant weight of their own. To learn the science behind spreads, you need to understand the general architecture of a currency trade. Most Forex trades happen through brokers.

Keep in mind that these aren't exactly middlemen, but facilitators. You have to pay them in spreads - which is the difference between the bid price and the ask price. Some brokers charge both spreads and per-trade commissions, so make sure you're getting brokerage worth the money put in.

How Bid-Ask Spreads Function:

As a Forex trader, you will be paying a specific price while purchasing a currency called the bid price. Similarly, when you sell a currency pair, you will do so for the ask price. The difference between these two rates will add up as the spread which is paid to your Forex broker.

To understand better, assume that you're buying a brand new phone. Once you've paid for it and start using it, you realize that it isn't worth the money and its market value is falling. So you go back to the shop to sell it, but the dealer isn't going to buy it for the same rate, he will pay you less for it. This is called the depreciation cost. In the Forex trading markets, spread work in a similar manner to this example. 

What Do Market Makers Do?

Forex trading isn't like stock exchange that usually happens in a physical space. Currency exchange happens over-the-counter and in a decentralized environment, meaning you can trade from anywhere in the world, and your trades are conducted by specialists known as market makers. Their job is to facilitate trades, find buyers for sellers and vice versa; these market makers charge spreads, and some even charge additional commissions. They only facilitate, you will have to do the other ground work, from devising Forex Trading Strategies to analyzing markets. 

While this market maker's job seems like easy money, it isn't; there's a lot of risk involved. If the specialist accepts a buy order and the currency's value goes up before selling it, he/she has to still remain committed to the trade and find sellers. 

Even when the bid-ask difference is minimal, market makers make ample profits. But since there's an element of risk involved, they hold on to a small portion of every trade which is called the spread. For example, when trading a currency pair A/B, if A is 1.1235 times B in value, it is natural to believe that A will rise against B, which will lead to you buying the A/B pair for asking price. 

This ask price won't be precisely 1.1235, it might be a tad bit more at say, 1.1240, which you will have to pay for the trade. Similarly the sellers won't receive 1.1235, a small difference will be caught and they will get 1.1230. This difference of 0.0010 is the spread.

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