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Forex Spreads

What is a Spread?

The spread represents the difference between the amount brokers will accept to sell a currency for (ask) and the amount that they will pay for a currency (bid). These prices change with time, but they are essentially always different from each other so that the broker is guaranteed to always make a profit. The broker's aim is to buy low and sell high; as a result, the ask price is always higher than the bid price. The spread is dependent on many factors. Some factors include the market demand for a particular currency, the market supply of a given currency, the liquidity of the currency, and the competitiveness of the currency. The main reason to be aware of the notion of spread is to maximize one's profits as a forex investor by minimizing the costs associated with engaging in currency trades.

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How Does it Work?

As any seasoned traveler knows, exchanging currencies while traveling abroad comes at a price. It is nearly impossible to be able to get the exact amount of a foreign currency as deemed by the exchange rate because the supplier of the currency normally pockets a transaction fee. The state of affairs is no different on the forex market. A broker gets paid a commission whenever one of his clients performs a currency trade. The spread acts as an additional mechanism for the broker to make money on top of his transaction fees. Investors cannot escape transaction fees; however, they can limit the extra costs that they must bear by shopping around for forex brokers who offer the lowest spreads. The key for investors is to understand that the forex market is actually quite close to being a competitive market. First of all, the volume of daily transactions performed on the forex market totals to approximately USD 3.1 trillion. Compared with the daily U.S. GDP of USD 37 billion, the size of the forex market is simply staggering: It has more than eighty times the volume! Not only large in terms of total wealth flows, the forex market comprises a bevy of individual transactions. Its size helps to ensure that the prices on this market are competitive. Hence, if one looks diligently enough, one can be sure to find competitive spreads.

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Examples of How the Spread Works

Let's solidify this discussion with an example. We want to show that the amount of profit that an investor can pocket decreases with the existence of transaction fees and bid/ask spreads. Suppose an investor has USD 5,000 to invest, buys GBP, but immediately regrets his decision, deciding to transfer his funds back into USD. We will assume that his broker charges a flat transaction fee of USD 20 per currency trade and that the bid/ask prices are given as USD 1.80/USD 1.90. The amount that the investor can spend on the first trade is USD 4,980 because of the initial transaction fee of USD 20. On the initial trade to GBP, he ends up with GBP 2,621.05 since the ask price is USD 1.90. At the end of the day, the trader gets cold feet and decides to wimp out, returning to USD. The bid price is USD 1.80, so he gets USD 4,717.89. The broker then takes another USD 20 in transaction fees, leaving the investor with USD 4,697.89. We see that the investor loses money in two ways here. The total amount that he is down is USD 302.11 of which USD 40 went to transaction costs. This means that the broker collected USD 262.11 just by having the spread!