Spreads and commissions are two main costs associated with forex trading, and understanding them is crucial for choosing a broker and calculating your trading profitability. Here's a breakdown of each:
Spreads:
- Definition: The spread is the difference between the bid price (price at which you can sell a currency pair) and the ask price (price at which you can buy a currency pair). It represents the broker's profit when they act as the market maker, or their markup on the price when they use an ECN or STP model.
- Impact: Tighter spreads are generally better for traders as they represent a lower cost per trade.
- Measurement: Spreads are typically measured in pips, which is the smallest unit of price movement for a currency pair (usually 0.0001 for most pairs, except for yen pairs which are quoted to 2 decimal places). For example, a spread of 2 pips for EUR/USD means the bid price is 2 pips lower than the ask price.
Commissions:
- Definition: A commission is a direct fee charged by a forex broker on top of the spread, for executing your trades.
- Impact: Commissions can significantly impact your profitability, especially for short-term, high-volume trading strategies.
- Structure: Commissions can be charged as a fixed fee per trade, a variable fee based on the traded amount (percentage), or a combination of both.
Spread vs. Commission Brokers:
- Spread-only Brokers: These brokers don't charge additional commissions on top of the spread. This can be appealing for beginners or those making infrequent trades. However, they may offer wider spreads to compensate for their lack of commission income.
- Commission-based Brokers: These brokers typically offer tighter spreads but charge commissions on each trade. This can be a good option for active traders who benefit from tighter spreads.
Choosing the Right Model:
The best model for you depends on your trading style:
- Frequent Traders: If you make many trades, commission-based brokers with tight spreads may be preferable despite the commission fees.
- Infrequent Traders: If you trade less often, spread-only brokers may be more suitable, even if the spreads are wider.
Finding the Best Deal:
- Compare Spreads: Look for brokers offering tight spreads for the currency pairs you plan to trade.
- Consider Commissions: If you're an active trader, factor in commission structures when comparing brokers.
- Account Types: Some brokers offer different account types with varying spreads and commission structures.
Remember, a demo account allows you to experiment with different brokers and assess the impact of spreads and commissions before risking real capital.