What Are Pips and Spreads in the Forex Market?

One of the draw cards for people who first start trading Forex is that there appears to be no cost of trading. That is, there is no commission charged on each trade - and therefore trading must be "free".

Whilst this is certainly true that there is no commission - trading is not exactly "free". If it was, there wouldn't be so many brokers to choose from in the market, because there would be no incentive for brokers to exist!

In reality, the way that a broker turns a profit is through something called the "spread". Let's take a look at this in detail now.

How the Spread Works

The spread is something which is present no matter which currency pair you decide to trade and no matter what time zone you choose to trade in. Essentially, the spread is the difference between the "buy" and "sell" prices quoted for a currency pair. This equates to the brokers profit.

For example, imagine that the current quote for the GBP / USD is 1.8031/1.8035. This quote implies that there is actually a 4 pip spread in the market - and therefore the broker will be earning 4 pips when you execute a trade (regardless of whether it is a buy or a sell trade) in the market.

The spread can therefore be considered the "commission" that a broker charges - and therefore it is looked upon as being a direct cost of trading in the Forex markets.

Minimizing the Spread for Higher Forex Profits

As logic follows, if you minimize your expenses, you are essentially able to maximize your profits. This is true for Forex trading also. When you are looking for a Forex broker for the first time, a good thing to do is to look out for the spread being advertised.

Try to choose a broker with a low spread - somewhere below 2 pips. Generally, 2 pips is the standard spread for the most popular currency pair EUR/USD - so if you are able to find a lower spread than this, you are probably getting a good deal.

But many people are probably asking - how does a lower spread cut trading costs and therefore maximize trading profit?

The answer is summed up in the following example. Say you are trading the GBP/USD and the quote is currently 1.8100/1.8105. This is a 5 pip spread. If the quote rises to 1.8120/1.8125 - you have made a 15 pip profit (the different between the buy price of 1.8105 and the sell price of 1.8120). However, if the spread had been just 2 pips, you would have entered at 1.8102 and exited at 1.8123 - a profit of 21 pips. 21 is more than 15 - so you've actually saved 6 pips!