Understanding Forex Spreads

08/25/2015 9:00 am EST

Focus: FOREX

Sam Evans

Instructor, Online Trading Academy

The system in place may be frustrating for new traders, but there are good reasons why currency trading works this way, says Sam Evans of Online Trading Academy.

Over the years, there has been plenty of debate about the positive and negative aspects of forex trading. I, personally, have been involved in the currency markets since pretty much the very start of my trading career and have always found them to be a perfect and powerful compliment to the other asset classes I have traded, like equities and futures.

However, the generic rule of trading any market is to make sure that you fully understand the dynamics surrounding it well before you put real cash at stake and forex is obviously no different in any way.

So, what should we be aware of before throwing ourselves fully into the world of currency trading? Well, to be honest, this one article alone would never give me enough time and space to go through absolutely everything the new forex trader needs to know. That is covered in its entirety during one of Online Trading Academy's Professional Forex Trader classroom experiences and then in the ongoing Web-based Extended Learning Track (XLT) program.

However, I would like to address two of what I feel are the biggest topics, or areas, that all currency traders need to be well aware of right from the very start. These are namely the role of the broker and the function of the spread in the actual trade.

The Broker
Time and time again in forex trading, I hear people moaning about their broker, and typically, it is usually the very same thing I hear over and over again: "My Broker took the other side of my trade," or, "Brokers hate it when you win in forex."

For a short while in my first few weeks of forex trading, I think I may have said the same thing from time to time, but now I look back and realize that I was actually just looking for somebody to blame for my lack of trading success other than myself. Hey, we have all done it, and while markets continue to trade, there will be more and more traders out there who think this is true as well.

In reality, though, it is a very different story. Let me explain.

First, the next time you feel like your stop loss has been hit because your broker wanted to make you lose money, then ask yourself a few questions before you get too angry. Why do you think the broker wants to take your trade out specifically?

What is it about you, as an individual, that made your broker take you out? Do they not like you? Was your position size really that big? Are they afraid that you are going to start making the market?

Really, when you ask yourself these questions, you may find that it is highly unlikely that any of the scenarios are really the case. Maybe your stop just got hit because price traded there?

It doesn't matter whether you are trading a broker's market derived from underlying prices or if you are trading the currency futures direct to the Chicago Mercantile Exchange where orders are anonymous. There will always be times when the market just hits your stop and turns the way you thought it would. That's trading.

The brokers in forex can't move the market alone, even when your orders are hidden in a direct access environment. Spend a little time building your trading experience and you will soon get a feel for where the majority of people out there are placing stop-loss orders. Sometimes they get hit and sometimes they don't, whether you can see them or not.

The major thing that many forex traders seem to forget is that brokers need to take the other side of your trade. This is what makes the forex market so liquid and allows us to all buy when we want to buy and sell when we want to sell. This is simply because the forex broker is willing to provide a bid and offer at all times, thus allowing us to enter and exit when we like, irrelevant of whether it is a winning or losing position.

Trust me, if forex brokers stopped taking the other side of your trade, you would enter a world of pain, finding it practically impossible to get fills on entries and facing huge slippage on stop-loss exits. Just ask any seasonal commodity traders what it is like to get stuck in a trade and have a stop loss that can't even be triggered, as there is not enough volume to find a bid or offer.

We need the broker to provide this service to us and a well capitalized dealer with deep pockets will happily provide a way in or out for the forex trader and then simply hedge that position immediately, so as to keep themselves flat in the market at all times. They make their money on the spread, which is our next topic of conversation.

NEXT: The Spread

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The Spread
The spread is how the forex broker makes their money, rather than charging a commission like you would pay to trade a stock or futures contract. It is defined as the difference between the bid and the ask (sometimes known as the offer). For example, if we were to quote the GBP/USD market price as 1.5850, the spread would look like the following:

chart
Click to Enlarge

With this in mind, if a trader wanted to buy into the GBP/$, they would pay the asking price, or 1.5852, and if they wanted to sell they would sell to the willing bid of 1.5848. This spread, which is captured on either side by the broker is, in essence, the service charge the trader has to pay for being able to enter and exit a position at any time.

As a rule of thumb, the wider the spread, the more volatile or less liquidity the pairing is or has,respectively.

When you consider that real-time forex data is free worldwide and that there are next to no platform charges for traders, then this becomes a pretty fair deal. The most important aspect to remember, however, is to account for this spread when using stops.

For example, if you were long the market with a stop at 1.3875 on EUR/USD and the spread was 2 pips, price would only have to travel to a market value of 1.3876 for your stop to be triggered. This is because if you were long, your stop would be an order to sell for a loss, and to sell, you would be selling to the nearest willing bid, which in this case was a pip below the market price. The same would then be true in reverse for someone short the market and looking to get a buy stop filled at the asking price.

No matter what asset class you choose to trade, or what style of market speculation you decide to employ, always make it your number one priority to fully understand not only the rules and regulations surrounding that market, but also the key dynamics which revolve around it, well before going live with your hard-earned capital.

Sam Evans is an instructor at Online Trading Academy.

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