Ever wondered how brokers make money from their clients? Well, it is through a simple concept of Spreads.
In the previous course, we discussed the terminologies such as pip, pip value, bid price, ask price, etc. In this lesson, we shall be extending our discussion and touch base on ‘Spreads’ in Forex.
What is Spread in Forex?
The difference between the ask price and the bid price is called the spread.
The “bid” is the price displayed by the broker at which one can Sell a currency pair. Similarly, the “ask” is the price offered by the broker at which one can Buy a currency pair. In both, “bid” and “ask,” Buying and Selling happen on the base currency.
So, the difference between these two prices yields some pips. And these pips become the profit of the brokers. This is how brokers make money without any commission.
In Forex, clients need not pay any additional fee to make a trade, as all the charges are built into the buy and sell prices itself. So, people must not get carried away by brokers who claim that they charge “Zero commission,” because traders will indirectly be paying commission in the form of spread.
How is spread calculated?
In the forex market, the spread is typically measured in pips, which is the smallest unit of price movement in a currency pair.
For example, let us say the current price of EUR/USD is 1.1500 / 1.1504. Here, the left quoted price is called the bid price, and the right quoted price is called the ask price.
Now, to calculate the spread, we just find the difference between the two prices.
So, Spread = ask price – bid price = 1.1504 – 1.1500 = 0.0004
Hence, the spread for this currency pair is 4 pips.
Note: Always subtract the lower price with the higher price.
Moving forward, let us say a trader wants to buy one mini lot of EUR/USD at this price. So, to do the buy, he/she will be paying the ask price (1.1504). And, to close the trade, he/she will be given the bid price (1.1500).
Assuming that they bought and closed (sold) immediately, they would be in a loss of 4 pips. Now, to obtain the loss in terms of cost, we need to multiply the cost of one pip by the number of lots they are trading.
Assuming that the value per pip is $1 for every mini lot, the total cost would sum up to $4. Total cost = 4 pips * 1 mini lot * $1 (per mini lot) = $4
Similarly, if they were trading eight mini lots, the total transaction cost would turn out to be $32. Total cost = 4 pips * 8 mini lots * $1 (per mini lot) = $32
Hence, this brings us to the end of this lesson. And in the next lesson, we shall elaborate more on this topic by understanding the types of spreads in forex.