Before we go any further, there are a few basic terms that you must understand when first getting started in the Forex market.
For every currency pair in the Forex market, there are two prices. One is what is known as a bid or sell price and the other is an ask or buy price. The bid price is the price at which the currency is sold and the ask price is the price at which the currency is purchased. Prices are listed as Bid/Ask.
Let’s take a look at a quick example. Let’s say there is a price quote for a Euro/U.S. dollar pair. You would see this as: EUR/USD and price is listed as 1.2883/1.2885. This means that the bid is 1.2883 and the ask is 1.2885. What does this mean to you as a trader? All it means is that traders interested in selling will need to sell at 1.2883 and those interested in purchasing will buy at 1.2885.
You might have noticed there is a difference between the two prices. That difference is referred to as the spread. The spread is the cost for conducting a trade. Every type of trade, whether it is a stock, bond, currency or whatever has a spread. So, using this example, if you purchased at 1.2885 and then immediately turned around and sold at 1.2883 you would incur a 2-point loss. As a smart trader, you would instead need to wait until the market moved sufficiently for you to at least break even before you sold. If you waited until the market moved 3 points in your favor, you would make a 1-point profit. Now, that’s not so hard to understand, right?
Basically, the spread is just your expenses involved in conducting the trade. It’s the cost of the trade. This is where the Forex trading company makes their profit. While a spread might at first glance appear to be relatively small, when you take into consideration the cost of all of the trades made, you see that it can add up very quickly. One of the first rules you need to understand about successful Forex trading is the importance of checking the spread before you make any trade decision. Always make sure you know the spread.
You might have seen the term ‘pips’ used in relation to Forex trading. What on earth is a pip and why do you need to be concerned about it? Pip refers to percentage in points. It is the smallest price increment. In the example above, you might have noticed that prices for currencies are actually quoted out to the 4th decimal point. As a result, a spread is actually 3 pips wide. The only time you will see an exception to this is in regards to the Japanese Yen, which is only quoted out to the 2nd decimal point.
The reason why pips are important to you as a trader is that the spread can vary quite a bit based on the parties involved and the executing firm. For instance, inter-bank foreign exchanges can frequently be seen with spreads that are extremely tight; perhaps only one to two pips. On the other hand, it is possible for a bank to elect to widen a spread; even as much as 40 pips. In exchange shops located near tourist hot spots, it is not unusual for spreads to reach as much as 600 pips.
In the last few years, Forex trading in general has become much tighter. This is due, in large degree, to the increase in market competition. Traders always need to be on the lookout for the tightest spreads they can find. At the same time, it is always important to be wary of anything that is quite a bit lower than what would be constituted by a typical spread. The reason is that the spread is the main source of income for Forex trading companies.
If you see an extremely tight spread, which would indicate the company probably isn’t going to earn much from the spread, you would definitely have good reason to suspect that there might be some other type of hidden fee somewhere in that transaction. Market conditions can also affect the degree of a spread. For instance, when market conditions are volatile, it is not unusual to see spreads widen. This increases the cost of trading.