Spreads and How Forex Trading Commissions Work
It is a well-known fact that the commissions involved in forex trading are much lower than those paid when trading on other products such as stocks, Stocks or commodities. If you're taking your first steps as a forex trader (or are contemplating doing so) it is important that you understand what a forex spread is and its bearing on the commission you'll be paying for transactions.
In the following paragraphs you'll find useful information about forex trading spreads and how they work.
In order to understand spread sizes and how they translate into actual sums of money you must first know what "pips" are. A "pip" in forex is the smallest figure used to describe the value of a particular currency. For instance, if the EUR/USD exchange rate is 1.0536 this means that every Euro is worth 1.0563 dollars, the fourth digit after the decimal point is the pip and so each pip is worth 1 hundredth of a cent.
When you use dollars to buy Euros the exchange rate for buying may be 1.0536 (this is the "ask price") but if you sell the Euros right back you'll find that the exchange rate is three pips lower than the ask price i.e. in this case- 1.0533 (this is called the bid). This means you will get 3 hundredths of a cent less for each Euro you had just bought. This 3 pip spread is the commission you are being charged for the transaction, in a 100,000 Euro transaction this amounts to 30$.
Forex Commissions are Much Lower Than Commissions In Other Markets
When compared to commissions paid when trading on stock, forex commissions (which, as demonstrated above, are based on 3 pip spreads) are very low. On a 10,000 Euro stock trade the commission paid will be half a percent which comes to 50 Euro. In comparison, the commission for a 10,000 Euro forex trade (based on a 3 pip spread), will be only 3$. This is the only charge for the whole trade.
Trading at a Profit
Traders profit by trading on products the value of which they believe will rise. A trader may begin a forex trade (for instance) buying Euros for U.S dollars. If after purchase was made the value of the euro rose, as compared to the U.S dollar, the trader stands to make a profit providing the exchange rate had risen enough to cover the initial 3 pip forex spread (which is responsible for the commission paid for the whole trade).
It is very important to understand that no profit was actually made so long as the trade was not completed. The trader must close the trade while the exchange rate is still in their favor so that ultimately the forex trading spread for the whole transaction is a positive one. A positive forex trading spread which is greater than 3 pips awards the trader a profit. The bigger the spread and the higher the sum traded the larger the profit made will be.
Transactions and Positions
A trading deal is not completed unless both a purchase and a sale were made. In forex, a trade is opened by buying a certain currency using another currency to pay for it (the two currencies are the "pair" traded). A forex trade is closed only when the currency bought is sold back. The term used to describe a complete trade deal (from beginning to end) is "position". In forex buying a certain currency is the act of opening the position. So long as the currency is not sold back, the trade has not been completed, no profit was made (or loss suffered) and the position is open (an "open position"). A completed position is one that has been opened and then closed, the actions of purchase and sale were both performed. Only once a forex position was completed is the final forex spread established and size of profit or loss is known.