When it comes to the world of Foreign Exchange (Forex), most people are not familiar with how Forex transactions take place.
Unlike the buying and selling of stocks, the process of Forex trading does not take place over a centralised exchange such as the Singapore Exchange (SGX). Instead, market participants buy and sell currencies through what is known as Over-The-Counter (OTC) markets. For that, customers find a trusted broker that provides them with access to the market and buy and sell currencies through them.
How Forex Trading Works?
Forex Trading refers to the exchange of currency pairs. For example, market participants can choose to trade US Dollar (USD) for Euro, if they believe that the Euro will fare better compared to the USD in the long run.
As there is no centralised exchange that governs the changing of USD for Euro (i.e. you can trade for these currencies wherever you want), or any other currency pairs for that matter, customers or traders can choose to go to any broker they trust to give them a competitive rate and quality service.
To start Forex trading, you would need to pre-fund an account with the brokerage provider that you have selected. Brokers would then provide you with leverage so that you can trade contract size that are larger than the amount you have put up.
For example, a $1,000 pre-funded account can allow traders to gain up to 50:1 leverage for major currency pairs. That means a trader is able to take up a currency position of up to $50,000.
Read Also: What Is Leverage Trading?
How Does The Bid-Ask Spread Look?
The bid-ask spread that Forex brokers provide for traders are similar to what you would encounter at a traditional moneychanger.
For each currency pair on offer, there would be a “sell” and “buy” column. This indicates the prices that Forex brokers such as IG would be selling and buying the currencies for.
Prices quoted by online brokers are usually live. That means they are able to offer much smaller spread, since the live updates allow them to make immediate adjustments throughout the day compared to traditional moneychangers who may only have one published rate each day.
Calculating Transaction Cost For Bid-Ask Spread For Forex Trading
It’s easy to get confused over how Forex quotes should be read. Let’s try to explain it in the simplest way possible.
Our Example – EUR/USD:
The currency in front (EUR) is called the base currency. The second currency listed at the back (USD) is called the quote currency. The “buy” & “sell” values that you see show how much it costs, in terms of the quote currency, to purchase the base currency.
|EUR/USD||What It Means|
|Sell||1.08871||If you sell Euro, you will receive USD 1.08871 for every 1 Euro you sell|
|Buy||1.08877||If you buy Euro, you pay USD 1.08877 for every 1 Euro you buy|
|Difference||0.00006||0.0001 = 1 Pip
0.00006 = 0.6 Pip
The difference between the “sell” and “buy” rate is called the spread. In this instance, the spread that IG is offering for the EUR/USD is 0.00006, or 0.6 pip, which is one of the lowest in the market.
If you are familiar with Forex, you will quickly realise just how small the online spreads are, compared to what you are used to seeing from banks or moneychangers, which could easily be 100 or more pips for every dollar exchanged.
For Forex Trading, traders tend to transact large amounts of money in each trade. For example, based on the 0.6 pip spread we see above, a $10,000 position would incur a transaction cost of about $0.60. A $100,000 position, also known as one standard contract, would incur a transaction cost of $6.
Different Spreads For Different Currency Pairs
The EUR/USD currency pair is the most frequently traded of currency pairs in the world. Hence, it makes sense that the spread for the currency pair is extremely competitive. For different currency pairs that are less liquid, the average spreads would differ.
To summarise what all this means.
- A) 1 Pip = 0.0001, or 0.01%
- B) Average Pip, 1.24 = $12.40, for every $100,000 contract
- C) $100,000 contract would require a margin of $2,000 to open, assuming a leverage of 50:1
Similar to how we take into consideration brokerage fees whenever we calculate our profits for stocks, we should likewise be familiar with the transaction costs we incur for Forex trading. A broker that gives you a competitive spread across major currency pairs would be one to look out for.
Aside from just looking at the spread the broker offers, you should also consider their reputation. That’s important because any orders that you make will ultimately be honoured by the broker you used. So ensure that you deal with a trustworthy broker.