Forex

What is forex spread and how does it work?

What is forex spread and how does it work?

What is forex spread?

Forex spread is the difference between what you can buy an asset for and its selling price. The price difference is the trader’s profit (or loss).

 

Forex spreads are charged per lot, with each lot containing 100 000 units of currency.

 

How it works

You wake up in the morning, ready to start your daily trading session; you log into your brokerage account. Only to realize that all of your stop-loss orders got filled yesterday because someone mistakenly pressed a button on their keyboard.

 

So now, not only did you lose money, but also you liquidated half of your investments. If this has happened before, I am sure you will agree that it sucks! If this story seems familiar to you, then we are sure that you are wondering what exactly happened there by now.

 

Well, some people might tell you that the broker was not doing their job correctly, but it’s nothing like that. It’s simply because of what forex spread is.

 

More than 50% of trading newcomers don’t know what it means. Let’s take a moment to explain it to anyone who might have missed out on this vital part of forex trading.

 

The easiest way for me to describe the concept is through an example:

 

Cora opened a new account with XYZ brokerage firm and purchased 10 000 units of GBP/USD for $1 each.

 

Now, her spread is 0.0001, and the margin requirement is 0.01% (10:1). The next day, Cora decides to sell her 10 000 units and receives $990. On the first day, she paid $1 for each unit, so It would seem as if she lost $10, right?

 

But If we look closer at where those numbers come from, we will see that Cora lost much more than just ten bucks!

 

How does forex spread work?

Let us now consider all the costs involved in trading, such as brokerage fees, execution fees and spreads.

 

In Cora’s case, these total up to around $20 –$30, so in essence, Cora lost $50 to $60, plus she still has her 10 000 units of GBP/USD.

 

When the broker sets the spread for each currency pair, they factor all these costs into it. When combined with the overnight interest rate (how much you lose by keeping your money on a trading platform instead of a savings account), traders often end up paying more than 30% in spreads and commissions.

 

OK, so we know how forex spread works, but why is it important?

 

Well, let’s say that you’re planning to open a new demo account; perhaps I can give you some insight into how it will perform over time.

 

Demo accounts are usually limited in the amount of money you can withdraw at any given time. For example, some brokerage firms allow you to make one withdrawal of $100 per day.

 

Now, if you were to open a ten lot GBP/USD position on the EUR/USD every time, you would withdraw $100, and you would completely drain your account in just five days.

 

This is because one standard lot contains 100 000 units of currency, so each withdrawal takes off 1% of your equity.

 

Now let’s see how much this difference could cost you over the long term:

 

Let’s say that Cora opened her demo forex trading account with the same brokerage firms he used for her live account, i.e. XYZ Brokerage firm and made a deposit of $10 000.

 

Assuming there are no spreads or commissions involved, she will have access to all available trading tools. Fewer withdrawals per week while others limit the number of withdrawals each month.

 

Meanwhile, on their part, demo brokers will charge a fee for each transaction and sometimes even for maintaining your account.

 

So, what happens when two opposing forces, such as interest rates and withdrawal limits, collide?

 

Well, there’s only so long before either interest rates or withdrawal limits win – it all depends on which one is higher!

 

Essentially, what we mean by this is that if you want to take out more than your maximum allowed withdrawal, then you’ll have to pay a fee if it’s an online broker, and the exchange rate may be less favourable.

 

However, if you’re an offline brokerage firm, you’ll need to pay interest on the entire amount.

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