How Forex Spread Affects Your Trading Profits
Forex trading is one of the most popular ways of making money in the financial markets. One of the main reasons why it has risen to the heights it enjoys today is because of the ease of entry and the ability to trade from anywhere around the world where there is an internet connection.
The emergence of mobile devices has also played their part with more traders now able to access the forex trading market via a smartphone or tablet.
However, while the FX trading market continues to attract more traders, it is important to take into account some of the essential elements of forex trading. One of the important aspects that every trader should strive to understand fully before joining the market is the forex spread. It is the primary cost incurred by forex traders the moment they open a new position.
As such, it is good to understand exactly how forex spread affects a trader’s account profits. To fully get a grasp of things, it is important to illustrate how the forex spread is derived and how its cost to an open trade is calculated.
The Bid-Ask forex spread explained
Those who have familiarity with the equities market, the bid-ask spread is basically the difference between the quoted bid price of a stock and the quoted ask price of the same stock. In the stock market, the bid and ask prices are determined by market forces.
In the forex market, things are a little different because it all depends on the type of your broker.
For those dealing with ECN forex brokers, things are a little similar to what happens in the stock market. The bid and ask exchange rates are determined by market forces. However, for traders using dealing desk brokers, popularly known as market makers, things are quite different. There are forex brokers that charge extremely high spreads but it is also possible to find low spread FX brokers in both dealing desk and non-dealing desk brokerage platforms.
A market maker determines the spread, which means different brokers will quote different spreads for their clients. For instance, one broket might decide to charge a spread of 2 pips in the EUR/USD currency pair (a pip is the smallest unit of an exchange rate up to the fourth decimal) while another might decide to apply a spread of 1.5 pips on the same.
How the forex spread is applied to a trade
A trader incurs a cost of 1.5 pips immediately after opening a new position while a similar amount is added to the loss (if the trade is closed in losing position) or subtracted from the profit (if the trade is closed in a profitable position).
As such, at the end of the day, for a forex spread of 1.5 pips, a trader incurs a total cost of 3 pips for opening and closing a trade.
Now, depending on the broker’s trading features and lot (a lot is the smallest quantity that a trader can place when opening a trading position) requirements, the overall cost can differ from one broker to another. Some brokers allow traders standard lots only, others have mini lots while micro lots are also becoming popular. A standard lot is 100,000 units while mini lots is a 10th of a standard lot.
So, in our example, a trader would incur a total cost of $15 for placing one standard lot, or $1.5 in the case of a single mini lot. The total cost will double after closing the trade, which means that it is crucially important that the trade is closed in a profitable position.
However, cutting losses can also be as effective in the case of a trade that is seemingly on a losing trend and does not look likely to recover.
In summary, the forex market provides traders with some lucrative money making opportunities. However, not all traders end up rich. In fact, statistics indicate that most traders lose money and close their accounts within 3-6 months of joining the forex market. This could be partly because they jumped in without considering the potential implications of some aspects of forex trading like the FX spread.
Therefore, it is crucial to understand how high FX spread can affect your trading profits and this could help in finding the right broker, perhaps a low spread forex broker.
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