Market Analysis
To comprehend the forex spread and how it affects you, you must first understand the fundamental structure of every forex exchange. One way to look at the commerce structure is that all transactions go via intermediaries who charge for their services.
This charge, which is the difference between the bidding and asking prices, is known as the "spread."
The Bid-Ask Spread Defined
The forex spread represents two prices: the purchase (bid) price for a specific currency pair and the selling (ask) price. Traders pay a set price to purchase the currency and must sell it for less if they wish to resell it immediately away.
Consider this easy analogy: when you buy a new car, you pay the market price. The car depreciates the moment you drive it off the lot, and if you wanted to sell it back to the dealer immediately away, you'd have to pay less.
In the automobile example, depreciation accounts for the difference, whereas in a forex trade, the difference is accounted for by the dealer’s profit.
Forex market makers determine the spread
The forex market differs from the New York Stock Exchange, where trading has traditionally taken place in a physical location. The FX market has always been virtual and operated similarly to the over-the-counter market for smaller stocks, with deals facilitated by experts known as "market makers."
The buyer may be in London, and the seller may be in Tokyo; an intermediary is required to organize the transaction.
The specialist, one of several who enable a certain currency exchange, could even be in a third city. His tasks include ensuring an orderly flow of purchase and sell orders for those currencies, which entails finding a seller for each buyer and vice versa.
In practice, the specialist's work carries some danger. It is possible, for example, that they accept a bid or purchase order at a specific price, but before finding a seller, the currency's value rises.
The specialist is still liable for filling the agreed buy order, and they may be required to accept a greater sell order than the one they have committed to satisfy.
The market maker keeps a portion of each trade as compensation for accepting the risk and arranging the transaction. The share they keep is known as the "spread."
A Sample Calculation
Every forex exchange involves two currencies, known as currency pairs. This example makes use of the British Pound (GBP) and the United States Dollar (USD), also known as the GBP/USD currency pair. Assume that, at any given time, the GBP is worth 1.1532 times the USD.
You may believe that the pound will appreciate versus the dollar, so you buy the GBP/USD pair at the asking price.
The asking price for the currency pair will not be exactly 1.1532. It will be slightly higher, say 1.1534—the price you will pay for the trade. Meanwhile, the seller on the other side of the exchange will not receive the entire $1.1532. They'll receive a little less, approximately 1.530.
The spread is the difference between the bid and ask prices, which is currently 0.0004.
The Cost of the Spread
Using the example above, the spread of 0.0004 British Pound (GBP) may not appear to be significant, but even a small spread can soon build up when a trade grows in size. Currency dealings in FX generally involve big sums of money.
As a retail trader, you may only trade a 10,000-unit lot of GBP/USD. However, the average trade is substantially greater, around one million units of GBP/USD. The 0.0004 spread in this larger trade is 400 GBP, resulting in a substantially higher commission.
How to Manage and Minimize the Spread
You have two options to reduce the expense of these spreads:
Only trade at the most favorable trading hours, when there are a large number of buyers and sellers. As the number of buyers and sellers for a specific currency pair grows, so does competition and demand for the business, and market makers frequently decrease their spreads to capitalize.
Avoid purchasing or selling lightly traded currencies. When trading popular currencies like the GBP/USD pair, multiple market makers compete for the same business. If you trade a thinly traded currency pair, you may find that only a few market makers will take your order. Given the reduced competition, they will maintain a broader spread.
Disclaimer
Derivative investments involve significant risks that may result in the loss of your invested capital. You are advised to carefully read and study the legality of the company, products, and trading rules before deciding to invest your money. Be responsible and accountable in your trading.
RISK WARNING IN TRADING
Transactions via margin involve leverage mechanisms, have high risks, and may not be suitable for all investors. THERE IS NO GUARANTEE OF PROFIT on your investment, so be cautious of those who promise profits in trading. It's recommended not to use funds if you're not ready to incur losses. Before deciding to trade, make sure you understand the risks involved and also consider your experience.