One of the basics on the FX market that you have to understand is the bid ask spread.  All FX traders will be confronted by the bid ask spread because it is part of the service offered by FX brokers.  It is important that you know what this spread is and how it is calculated.  You should also know why you are charged a spread and how this can impact your FX trading.

What is the Bid Ask Spread?

The first step in understanding the basics of the bid ask spread is knowing what this spread is.  The bid ask spread is the number of pips between the bid and ask prices that FX brokers offer you.  The bid and ask prices will always be different and this difference can be as much as 8 pips or as little as 0.5 pips.  The spread you get will depend on the scheme your broker is using and the market conditions.

The Spread Schemes

There are two different spread schemes that FX brokers use which are the variable and the fixed schemes.  With the variable spread scheme the spread will vary depending on the market conditions and the currency pair you are looking at.  The fixed scheme will offer you the same spread all the time, but this will vary depending on the currency pair you are using.

Market Conditions and Currency Pairs

The market conditions will only affect the spreads that you get from brokers using the variable spread scheme.  This is mainly related to the supply and demand of a currency pair.  When the demand for a currency pair is high then the spreads will become tighter.  However, when the demand is low then the spreads will widen.  Of course, this is the rule of thumb and is not always the case as some brokers will take advantage of the increased demand and widen their spreads.

The currency pairs being looked at will affect both fixed and variable spreads.  With the fixed spreads the common currency pairs will have tighter spreads while the exotic currency pairs will have wider spreads.  The same can be seen with the variable spreads.  However, with the variable spreads the changes in spread amounts will not be as great with the exotic pairs as with the common pairs.

Why Spreads are Charged

You will be charged a spread because the forex broker you work with needs to make money.  Brokers on other financial markets will charge a commission for the trades that you complete.  However, the forex brokers do not charge a commission generally.  The ones that do are usually the ECNs who are not making money from the spreads on offer.

The Spreads and Trading

Short-term traders are more commonly affected by the spreads than long-term traders.  There are some short-term traders who do not actually see any negative impact from the spreads.  These are generally intra-day trend traders who are looking at high pip profits.  However, if you are using a strategy like scalping where you are making limited profits you could find these affected by the spreads.  These traders need to find brokers that offer consistently tight spreads otherwise their trading may not be worthwhile.