If you have been browsing the Web in search for an online Forex broker that "feels right" and seems to best suite your needs, you may have read or heard several times a phrase that sounds tremendously attractive to a newbie FX trader:
We charge no commissions on your trades: we are compensated through the difference between the the buy and sell price.
But what does this all mean? Will your profit margins be higher if you do not have to pay commissions? Unfortunately, as we will see, this is not necessarily the case.
The number known as "spread" is quite simply the difference between the buy and sell price. This terminology is not limited to the world of the foreign exchange market as it is used in other contexts too — we can talk about spread to characterize the exact same thing in other markets, such as stocks, futures, and options.
You may be asking yourself, why is there a need to keep in consideration two prices instead of one? The answer is simple: for an asset to be traded, there has to be a "market" for it, that is, if you want to buy there has to be someone willing to sell you, and vice versa.
Spreads are usually measured in pips (short for "points in percentages"), which are the smallest price change that a given currency pair can make. You can see what the spread for a certain trading account is by logging into your trading platform and making a simple calculation.
For instance, suppose you see that the current buy price (ask) for EUR/USD is 1.1432, while the sell price is 1.1429: this means that the spread is 1.1432 − 1.1429 = 0.0003 = 3 pips.
Online FX brokers can offer you two kinds of spreads, fixed and variable. While variable spreads are typically lower, they change with the market and can face unexpected jumps, therefore causing a significant loss for your positions, especially if you like to trade with the technique known as scalping.
The main advantage of not having to pay a commission on each trade is that you will not be penalized if you choose to invest in a small quantity of lots at a time: the spread, and therefore the initial loss you have to face once you enter a trade, is proportional to the product of the spread itself and the amount you are investing.
In the earlier example, if we have a USD account and buy a standard lot of 100,000 units in the EUR/USD pair, our initial loss due to the hidden cost of the spread will be 0.0003 x 100,000 = $30, and each pip is worth $10; but if we invest a mini-lot of 10,000 units, we will only lose $3, with a pip value of $1.
The fact that the brokers are compensated by the spread also means that they do not make more money if you lose on a trade, nor more if you win. As a matter of fact, online brokers really want you to gain on your trades, so that you will be able to invest more and more money with their platform. Some of them even encourage trading relatively large amounts on "quick" trades with a risk of loss amounting to just a few pips — the technique called scalping, as we were saying — because the more you trade with them, the more they earn.
On the other hand, having "no commissions" on trades, novice currency traders may be brought to believe that the brokers do not profit at all from your trades, which would of course be absurd. As always, you should review the conditions offered by a Forex company very carefully before investing your money with it.