Have you ever wondered how forex brokers make their profits even though they do not charge any commissions for their service?

The answer lies in the bid price and ask price, and the difference between the two which is known as the spread.

The bid price represents the highest price at which traders are willing to purchase a currency. On the other hand, the ask price is the lowest price that a broker is willing to pay for a currency.

A transaction is completed when a trader accepts the ask price or when the broker takes the bid price. Upward trends occur when buyers of a particular currency outnumber sellers as this pushes the bids higher.

On the other hand, downward trends occur when there are more sellers than buyers as this will force sellers to offer lower prices.

What to Consider With Spreads

Not all currencies attract the same spreads. The spreads are determined by a currency’s liquidity as well as its supply and demand in the FX market.

The most liquid currencies, known as the currency majors, have the tightest spreads as long as there are no major shifts in either supply or demand. Exotic currencies attract the highest spreads.

Bid/ask spreads represent a hidden cost which most forex beginners fail to take into consideration when formulating their trading strategies or making their trades.

This is because the bid-ask spreads are not always apparent and only add up to a small figure for traders who do not trade frequently or in large transactions.

However, the bid-ask spreads add up to a significant amount for frequent traders who trade in large amounts.

A very serious concern for forex traders is the fact that due to high leverage levels offered by brokers, the bid-ask spreads can be form a very high percentage of the invested amount.

An example of how bid-ask spreads work in the highly-leveraged forex market is as follows:

Forex Leveraged Bid-Ask Spread Example

The current quote for EUR/USD = 1.3300 / 1.3302 which gives us a bid-ask spread of 2 pips.

We can use this to calculate the spread percentage as follows:

Spread percentage       = Spread / Ask

= 0.0002 / 1.3302

= 0.015%

When a trader purchases a standard lot worth € 100,000 using a margin of 200:1, then the spread will be as follows:

Spread                         = 0.015% x 100,000

= 1500

But our trader had a 200:1 margin so the percentage spread is:

Percentage Spread      = (Spread / Equity) x 100

= [1500 / (100,000 / 200)] x 100

= (1500 / 500) x 100

= 300%

So you can see how the spreads on a leveraged trade shot up from 0.015% to 300%.

Bid-Ask Spreads Tips for Forex Traders

When trading forex, if you place a market order on the current conditions these might change at any moment and result in you being charged higher spreads.

It is much better to use limit orders which take into consideration the highly fluctuating FX market.

Using limit orders also enables a trader to avoid liquidity charges imposed by Electronic Communication Networks (ECN).

Remember to always evaluate your spread percentages for each trade based on your equity and not on the total leveraged amount.

A very important tip is that as you make a decision on which forex broker to trade with, take your time to shop around for one who offers the narrowest spreads for the currency pairs you wish to trade in.

Click here for a balanced review of some of the best brokers in the market.