Forex trading spreads, pips and fees explained
Your simple guide to forex trading costs and technical jargon.
The world of forex trading can seem confusing and sometimes downright intimidating to newcomers. Not only do you need to grasp the basics of trading and how the market works, but there's also a wide range of technical jargon you need to decipher.
From the commission and the spread to something called pips, there's a lot to wrap your head around before you can start trading. Let's take a closer look at what these technical terms mean and how they affect the cost of trading.
How much does forex trading cost?
Unlike share trading, where the fee an online broker charges for each trade is clearly set out in black and white, the main cost you need to be aware of when trading forex is something known as the spread.
Rather than paying a flat commission or fee on your trade, the spread is the primary cost that applies to most forex pairs. And here's where things start to get a little more complicated.
What's the spread?
No matter what currency pair you're trading, your broker will list two prices – the bid price and the ask price. The bid price shows the value at which you can sell the base currency of the pair, while the ask price is the price at which you can buy it from the broker. (Remember, the base currency is the one listed first.)
The difference between these two prices is known as the spread, and the ask (buy) price is always higher than the bid (sell price).
Taking the AUD/USD currency pair as an example, you might see your broker listing a sell price of 0.76594 and a buy price of 0.76604. Subtract the sell price from the buy price and you get a spread of 0.0001.
But the deeper you dive, the murkier things become for novice traders. This is because brokers commonly quote the size of the spread in something known as "pips".
What are pips?
As you've probably guessed, the term pips in this context doesn't refer to the seeds in an apple or watermelon. Instead, pip actually stands for "percentage in point" or "price interest point".
With this in mind, a pip is a standard unit of measurement that defines the smallest possible price change between a pair of currencies. For example, a broker might announce that they offer minimum spreads on the AUD/USD currency pair from 0.6 pips. Some brokers will also use points instead of pips when outlining the spread.
Now, let's take a look back at our AUD/USD example from higher up the page. Remember, this featured:
- A sell price of 0.76594
- A buy price of 0.76604
- Resulting in a spread of 0.0001
Most brokers quote currency pairs out to four or five decimal places. And for most major currency pairs, a pip is equal to a price movement of 0.0001 – in other words, check the fourth decimal place of the currency pair for price changes. So in our example above, the spread is 1 pip.
However, it's worth noting that the bid and ask prices for Japanese yen currency pairs are only quoted to two decimal places. As a result, a pip is equal to 0.01 for JPY pairs.
SPONSORED: We explain the basics of forex trading in Australia, what a currency pair is and the benefits and risks of trading foreign currencies.Read more…
What does the spread mean for me?
Have you ever seen "no-commission" forex trading advertised and wondered how the broker makes any money? While a broker may not charge any commission on trades, that doesn't mean they offer their services for free.
Instead, rather than charging you a separate flat fee, the spread essentially allows the broker to incorporate their commission as part of your transaction. That's how brokers make a profit – they sell currency at a higher price than the price they buy at.
Of course, there are also other factors that can affect the size of the spread, including the volatility and liquidity of the currency pair you're trading. That's why major currency pairs have tighter spreads than emerging market pairs.
Calculating the cost of a pip
Now it's time to think about how the price movement in a currency pair affects your potential profit or loss. To do that, you need to calculate the value of a pip, which depends on the pair you're trading, the exchange rate and the size of your trade.
If you're trading a major currency pair where 1 pip = 0.0001, the formula is simple. Pip value = (trade amount x 0.0001) / the current spot price of the forex pair.
Let's say you place a $10,000 long trade on AUD/USD at 0.7651. The value of AUD/USD then increases to 0.7681 – an increase of 0.00300, or 30 pips.
The value of a pip is (100,000 x 0.0001) / 0.7681. So 1 pip is $13.02, and the profit on the trade would be 30 x $13.02, or $390.60.
What other costs do I need to be aware of?
While many brokers make money from the spread rather than a commission, some also charge a separate flat commission on all trades. This means they may offer tighter spreads than you can find elsewhere, but you'll need to consider the total cost of trading before deciding if this approach will be more cost-effective for you.
If you're a casual trader, you might be best suited to a zero commission account, depending on the broker. In this case you'll want to look for the lowest spreads on no-brokerage-fee accounts. For example, IC Markets boasts some of the lowest spreads for its standard account, at 0.77 for AUD/USD and 0.626 on EUR/USD and no brokerage costs. These spreads can fall as low as 0.0 pips on its commissioned accounts. These spreads accurate at time of publishing: June 24, 2021.
One other common fee to keep an eye out for is an inactivity fee. This fee is often charged on a monthly basis once you haven't made any trades from your account for a set period of time, such as 12 months.
Other trading charges may also apply. For example, you may be charged interest if you want to keep a position open overnight, the broker may charge a fee when you want to withdraw funds from your account, or a currency conversion fee could apply if you trade in a currency other than your account's base currency. With this in mind, be sure to read the terms and conditions of your trading account closely.
If you're new to forex, there's a steep learning curve in front of you. But once you understand the jargon, and if you're willing to research the ins and outs of how the market works, you'll be in a much better position to start trading.
Lead image: Getty
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