Forex Spread BasicWhat is Forex Spread?

Imagine walking into a store and spotting a t-shirt that would fit into your wardrobe perfectly. You stop in front of the shirt, and what is the first thing you do? You will naturally search for the price tag. After noting the price, you will examine the quality of the shirt and determine whether it is worth the price asked by the store. When trading on the Forex market, the spread is your price tag.

Learning about forex spreads is the single most important thing a new trader can do.  

Forex Spread: A Basic Definition

When you trade on the Forex market, you always trade in currency pairs. Pairs are noted together, such as EUR/USD. For each trade you enter, you will buy or sell a position in the market for one specific currency pair. In order to determine whether you should buy or sell a position at a given time, you have to determine the spread.

The most basic definition of a spread in Forex is the difference between the bid price and ask price for a particular currency pair. The bid price will always be lower than the ask price. You will see this reflected in pips rather than any particular currency.

Consider an Example

Let's walk through an imaginary scenario so that you see how bid price, ask price and spread all come together to point the direction toward a profitable Forex trade.

Imagine the current bid price for EUR/USD trades is currently 1.60. This means two things to you as a trader:

  1. If you are buying a position with these currencies, the second currency in the pair is the one you currently have in your possession. So, you would pay $1.60 from your Forex account funds for each euro you want to purchase. You would multiply $1.60 by the number of euros you want to purchase to determine your total cost of buying that position with the number of shares you desire.
  2. If you are selling a position with these currencies, the first currency in the pair is the one you currently have in your possession. So, for every euro that you sell, you will receive $1.60. This is multiplied by the number of shares sold.

Now, imagine the ask price for this currency pair is 1.62. The difference between the bid and ask price is .02 which translates into 2 pips. A "money maker" could purchase positions for 1.60 and then sell those positions to traders for 1.62, earning those 2 pips on every share sold. This is how your broker makes money by trading currencies with you and other traders.

Forex Spreads - Detailed Example

Brokers Need Paychecks Too

Brokers don't enter into trades because they just want you to make some extra spending cash or get rich enough to quit your day job. They enter trades because they need to earn money, and they don't mind you making money if they are able to do the same. They don't want to charge you fees that may discourage you from playing the game, so they advertise zero commission and collect through the spread.

That's the first thing you need to understand about Forex spread: it's the price tag on every trade and your broker's paycheck.

When Do You Pay the Spread?

Once you buy or sell a position, you have already covered the spread. Most brokers no longer charge commissions, and many advertise no fees at all. They are profiting from the spread, and you cover that automatically at the close of each trade.

To put this into perspective, go back to the t-shirt that you spotted on the store rack at the very beginning of this page. The price you see on the shirt's tag is the full price. You pay that amount and receive the shirt without any sales tax. The Forex market is essentially a tax-free marketplace.

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