New Forex Trader Basics: Understanding Spread
Spread is by far one of the most common costs associated with forex trading, and it is a vital concept to understand. As a new forex trader, spread is something that will impact your trading a great deal and it is very important to know where it comes from and how it affects your trading.
At any given time, the price you see on your forex chart or from your broker is really just one of two prices. The easiest way to understand this is consider buying and selling a ring at a pawnshop. If you were to “pawn” or sell your gold ring, the pawnbroker would offer you a lower price than he/she will end up putting it on sale for later. Pawnbrokers are in business to make a profit, and that is how they make a substantial portion of their profit. In fact, virtually all buying and selling in the world done for profit operates in this manner.
When you as the consumer are buying something it is typically at a rate higher than what the seller bought it for. When you go to sell an item as a consumer back to the same retailer (unless it’s an unopened return in the case of retail stores and even then there are sometimes “restocking fees”), they will likely offer you less than what you paid for it.
Brokers, in the forex market, operate in the same fashion. They are a middle-man, connecting you as the trader, with an interested buyer or seller, and in this case it’s a commodity called currency. When you “buy” or “go long” on a forex pair, you are buying one currency and selling another. The broker facilitates this transaction for you, and therefore charges a fee. This can come in the form of commission, but for this article, we are going to discuss the spread which can be used instead of a commission or in addition to one.
Back to the forex chart, most brokers only display the “bid” line, or the price that they are willing to sell you the pair at. But there is also an “ask” price above that bid line which is the price they are willing to buy the pair from you for. If you open your order display in Metatrader you will see both prices and usually a graph with two lines moving almost in tandem. The difference between the “bid” and “ask” price is known as the spread and it is a trading cost, because you are always going to be able to buy the pair for a higher price than you can sell it for at any particular place in time.
This ensures any trade you start is always going to be slightly (or in the case of a high spread, much more) at a loss to start the trade. If your trade goes in your favor, this spread “disappears” by the time you are in profit, but essentially what’s happening is you are paying the spread FIRST, then whatever gains you might make on the movement become profits. Spread varies from broker to broker, and from market to market, and even from time to time on the same pair on the same broker. But reducing spread is covered an another article.