Blog
Introduction
We have covered a number of key topics already in our blog but there probably still more questions you want to ask. Like, how do Forex brokers make money, or are they offering a free service? You may also want to know more about price, the bid and ask price, and how your profits and losses will be measured.
Here, all of your questions are answered.
Spread
So, how do Forex brokers make money? First, they are not a charity, brokers charge for their services. To be able to understand the costs, we need to revise how brokers work and explain the dynamics of price.
Every currency pair has two quoted prices. They are the bid and the ask. The bid price is the price at which you sell the pair. The ask price, on the other hand, is the price at which you buy it. For example, for the EUR/USD pair, a broker can display the quote: Bid Price/Ask Price: 1.1055/1.1057. The difference between these two is 2 pips and is called the spread. It is the fee that accrues to your broker for handling the transaction on your behalf. You might note that the bid price and the ask price are never the same. The bid price is always lower.
That makes sense because for the broker to be able to make a gain, you have to be selling at a lower price and buying at a higher price. Usually, the major currency pairs, most especially the EUR/USD pair, carry smaller spreads as a result of their huge liquidity — they are frequently traded. You might also consider that whenever you want to make the choice of your preferred pair to trade.
Apart from spreads, Forex brokers can make money through commissions instead. In exchange for helping to execute your buy and sell orders, your broker can choose to charge a commission per trade instead of a spread. Sometimes brokers can charge both commissions and spreads on the trades they execute for their clients. And when they do not charge commissions, they widen their fees in spreads.
Spreads can be either variable or fixed. Variable spreads, as the name implies, change with market conditions. When a currency pair is experiencing extremely high volatility as a result of a recent economic announcement, a variable spread can widen. Depending on the specific stimulus and your broker, variable spreads can be favourable for you or not.
Fixed spreads, on the other hand, do not change with market conditions. Always, what you see is what you get. You should pay attention to the fee your broker charges, spread or commission or both, because fees can easily eat into your profits and make trading far less profitable than it can be.
Pip
Every business has got its unit of measurement. Same with Forex. Or how would you be able to quantify your gains and losses when you trade without a unit? Oh, you can ask, “But what of dollars?” Well, when you are creating a system intended to be of the magnitude of Forex, you need to use a unit that cuts across different currency pairs. And a pip is that unit.
Known as “percentage in point” in full, it is the smallest value by which the exchange rates of currency pairs change.
Take the EUR/USD for example. If the exchange rate is 1.10955, this means that 1 Euro is equivalent to 1.10955 USD. A change of 1 pip will be the change in the fourth decimal point, that is 0.0001. Thus, the dollar value of 1pip is $0.0001
However, as far as Japanese pairs are concerned, there is something relating to pip about them that you need to know. While the major currencies are traditionally priced to four decimal places, Japanese Yen currency pairs, on the other hand, are priced to just two. As a result, the pip, for Japanese Yen currency pairs, is the second decimal point.
Hence, if USD/JPY has an exchange rate of 102.55, this means that 1 USD is equivalent to 102.55 Yen. A change of 1 pip will be the change in the second decimal point, that is 0.01. This means that the Yen value of 1pip is 0.01 Yen. To convert this to USD we just need to divide 0.01 by the USD/JPY exchange rate. Doing this gives us $0.000098
Slippage
Although rare in the Forex market, you should know about it. Slippage is when the price at which a trader places an order and the price at which it is filled are slightly different. Slippage is especially common when there is huge volatility in the market, usually as a result of an economic release. Other times, it is simply the fault of the broker.
Here is an instance of slippage at work. Assuming the price of the EUR/USD pair is 1.1087. Based on your analysis, you think the price will move up. So, you place a buy order. However, the market moves down so fast that the broker can’t fill your order at your stipulated price. Instead, it does so at the next best price for you which is, say, 1.1084.
That price automatically gives you an advantage — a potential higher gain — of 1.10870 – 1.10840 which is 3 pips. This is an example of situations when slippage can be to your advantage. However, other times slippage can be a disadvantage.
For example, you analyse the same currency pair, which is currently at a price of 1.5489, and you think it will come down.
So, you decide to place a sell order at that. However, unfortunately, your broker cannot fill the order until the price hits say 1.5487. This is slippage, which will have already put you 2 pips behind, even if the price keeps falling.
A more painful experience of slippage is when your broker cannot keep your stop-loss order as a result of uncontrollable volatility in the market.
Are you eager to combine all those terms and see how they work together in real trading scenarios? Check us out here and start trading!
