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Forex Spreads - How they work.


One of the first things you need to understand when learning about forex is the forex spread. Understanding the forex spread is probably the most important step in figuring out how forex trading works. The spread is the difference between the bid price (the price you sell at) and the ask price (the price you buy at), quoted in pips. (A pip is 1/100 of one percent.) For example, if the quote between EUR/USD at a given moment is 1.4222 / 1.4223 (sell vs. buy, sometimes expressed as 1.4222/223), then the spread is 1 pip. If the quote is 1.4222 / 1.4232, then the spread is 10 pips.

forex spreads chartThis spread is also how banks and brokers make money. Wider forex spreads mean a higher ask price and a lower bid price. As a consequence, you pay more when you buy a currency and get less when you sell, making it more expensive for you.

It's basically the same as when you go to a bank - the bank will charge a certain rate if you're buying a currency, and a slightly different rate if you're selling a currency. This is in effect where they make their money. If the bank simply bought and sold a currency at the market rate, they would be doing it for free and not making any money. Almost all forex brokers will earn their profit through the spread, but just as with banks, some offer better rates than others.

Most forex brokers do not charge a fee for their clients to buy and sell currencies - their profit is built in to the spread you see between the bid price and the ask price. That's why it's important to shop around and choose a forex broker that's offering a reasonable spread. While you don't want to choose a forex broker solely on the spreads they offer, it is one of a few important considerations before trading forex with real money.

Banks and forex brokers typically don't earn the full spread because they, in turn, must hedge out net client foreign currency exposure with other banks, which costs them the spread as well. The spread compensates forex brokers for taking on the risk that the price might change from the time they execute a client's trade to the time they safely hedge their net exposure with a bank.

Besides forex spreads, one of the terms you will hear most often in learning about forex is the "forex pip". A pip is 1/100 of a percentage point, and is how we track upward or downward movement in a currency. If you understand how forex spreads and pips work, you have a very good basis for understanding how forex trading works.



Forex Pips.

The spread in forex between two different currencies is measured in "pips". A pip is the smallest price increment in forex trading - pip stands for percentage in point. A pip is 1/100 of a percentage point. However, because forex trading allows you to use leverage to trade much larger volumes of currency than you have in your account, an increase of a few pips can result in a substantial profit.

Prices are quoted to the fourth decimal point in the forex market - for example EUR/USD might be bid at 1.1914 and offered at 1.1917. In this example we can see that the spread is 3 pips wide. If the spread then changed to 1.1914/1.1919 the spread would then be 5 pips. The Japanese Yen (JPY) is the only exception - it is quoted only to the second decimal point. Forex trading always involves trading a currency pair, which is explained below. the evolution of forex

The reason pips are so important is because they are the basis for calculating profit or loss in forex trading. If your currency is up 10 pips over a certain period of time, you have made a profit. If your currency has lost pips, then you have lost money. As you're probably already starting to see, forex trading is much simpler to figure out once you start to understand all the jargon and terminology.

The last big 'concept' you need to understand to have a good understanding of forex is that the basis of forex revolves around currency pairs. This means you buy one currency at a certain value against another currency, with the intent that the base currency will increase in value against the other currency - thereby creating a profit for you.

Different currency pairs have different spreads depending on the pair, as certain currency pairs are less liquid, have less trading volume, etc. When comparing forex spreads between brokers, make sure you are comparing the same currency pairs to ensure you're getting an accurate picture of what kind of spreads they offer. We will explain forex currency pairs and how they work.

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Forex Currency Pairs.

All forex trades involve the simultaneous buying of one currency and selling of another, but it's easier to think of the currency pair as a single unit, an instrument that is bought or sold. If you buy a currency pair, you buy the base currency and sell the quote currency. The bid (buy price) represents how much of the quote currency is needed for you to get one unit of the base currency.

Conversely, when you sell the currency pair, you sell the base currency and receive the quote currency. The ask (sell price) for the currency pair represents how much you will get in the quote currency for selling one unit of base currency. Currencies are traded in pairs and exchanged against each other.

The majority of currencies are traded against the US Dollar. The first currency in the exchange pair is called the base currency,  while the second currency is called the counter currency or the quote currency.

The exchange rate tells you how much of the counter currency must be paid to buy one unit of the base currency. The exchange rate also tells the seller how much is received in the counter currency when selling one base unit. For example, an exchange rate for EUR/USD of 1.2083 specifies to the buyer of Euros that 1.2083 USD must be paid for one Euro.

While there are hundreds of currencies around the world, only a handful of currencies are involved in the forex market, and these are usually referred to as the "majors". These form what are the most commonly traded currency pairs, and these are what most forex traders concentrate on when trading forex.

Most commonly traded currencies or the "majors" are:

the major forex currency pairs US Dollar (USD)
Japanese Yen (JPY)
Euro (EUR)
British Pound (GBP)
Canadian Dollar (CAD)
Australian Dollar (AUD)
Swiss Franc (CHF)

Most commonly traded currency pairs:

US Dollar and the Japanese Yen (USD/JPY)
Euro and US Dollar (EUR/USD)
US Dollar and Swiss franc (USD/CHF)
British Pound and US Dollar (GBP/USD).




Currency pairs are generally traded as 100,000 units of the base currency. For example, if you were buying EUR/USD at .97 you would be paying Dollars for Euros as follows:
100,000 x .97 = $97,000 for 100,000 Euros. The quote currency is translated into a certain number of units of the base currency. For example, a quote of USD/JPY at 1.20, says that for every 1 US Dollar, you get 1.20 Japanese Yen, while a quote for AUD/JPY of 67.73 says that for every 1 Australian Dollar, you get 67.73 Yen.

Just from reading the information on this page you now probably have a pretty good understanding of the basics of forex. Forex trading centers around currency pairs (usually "the majors"), and you buy a certain lot of currency in the hopes that it will increase in value (in pips) and you will turn a profit. That is forex trading in a nutshell. The tricky part in forex trading is learning the fundamentals of the currency markets, and what makes a currency go up or down.

After you read more about forex, the best way to really understand forex is to open a free forex demo account, and trade forex using pretend money - then you will really understand how it works. We would caution anyone against trading forex until they have practiced with a demo account for a few weeks to get the hang of it. Once you are completely comfortable with trading forex in your practice account, then is the time to put in your first deposit and start trading forex with real money.



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