Introduction
The Tasty Forex Spread
The foreign exchange market or the forex is where currencies are simultaneously traded. The forex quotes are the bid/ask prices in which you can sell and buy one currency for another. The "spread" is the difference between these two prices in the forex quote. And if you're wondering what affects profitability more, it's the spread.
Now, forex quotes are market indicators and are stated in "pips" which is the smallest unit price for currency. Generally, currencies are traded at four decimal places with the exemption of the US dollar/Japanese yen which is traded at two decimal places. One pip, or a tick, is 0.0001 of a cent.
Normally the word "spread" is used in trading like, "There's a five pip spread on the USD/CHF." This statement means that you can buy one US dollar at 0.0005 of a Swiss franc more than you can sell it in the market. And in the forex quote, the bid price is always less than the ask price.
So how does this spread affect profitability? The proverbial rule to making profits is that you have to sell at a price that's higher than the cost. The spread just so happens to be the cost of taking a position in currency trading. So as a trader, entering to a trade or position means that you will have to incur an immediate or automatic loss equal to the spread. And being profitable or not depends if you can sell at a price that's less, equal or higher than the spread.
For example, the USD/CHF is quoted at bid/ask prices of 1.2022/1.2027. The selling price for US $1 is 1.2022 Swiss francs and the buying price for US $1 is 1.2027 Swiss francs. There's a five (5) pip spread on the quote (1.2027 -1.2022 = 0.0005 pips).
If you decide that the US dollar will appreciate, you'll enter into the trade by buying US dollars for Swiss francs at 1.2027 to a US dollar now and sell them later. If you were to immediately turn the trade around by selling US dollars before the quote moves, you would have to do it at the bid price of 1.2022 Swiss francs to a US dollar. That's the immediate loss equal to five pips or 0.0005. So in order to break-even, you'd have to sell at the bid price equal 1.2027. And in order to recover the cost and earn profits, you'd have to sell at the bid price that's more than 1.2027.
So what spread should a forex trader look out for? A tighter spread, for sure. That's when bid/ask prices are not too far from each other. This means that the sell price would not have to appreciate so much for a trader to recover the cost of the trade and earn a profit.
When you want to be profitable in the forex, you have to grasp the fact that there is an immediate loss when you enter into a position to trade in the foreign exchange. That immediate loss is the spread. Remember, when you sell at less than the spread you'll incur more losses. When you sell at the spread, you'll simply recover the initial cost. When you sell at more than the spread, you'll not only break-even but you'll earn profits as well.