By: Hillel Fuld

Forex trading is constantly growing in popularity. New Forex brokerages are opening at an extremely high rate. Many people who are used to working 9-5 jobs are now leaving their jobs and starting to trade Forex. There are many explanations for the growth of the Forex market, some of the obvious ones being its size, its simplicity, and its potential for profit.

When one thinks about Forex as opposed to other global markets such as the stock exchange, some very basic differences should come to mind. These include higher liquidity, more volatility, greater leverage, as well as lower trading commissions and costs. We have already discussed the liquidity, volatility, and leverage offered in the world of Forex, so now we will learn a little bit more about the trading costs and commissions as compared to other global markets.

Let us take the stock market for example. When one trades stocks, which by the way is a very common occurrence for Forex traders (a lot of people fail at stock trading and then turn to Forex, and rightfully so), the standard way trades are conducted is with the trader being charged commission on both sides of the trade. What does that mean? When you trade stocks, you are generally doing it in cooperation with a broker, and that broker charges you a fixed dollar amount per trade, a dollar amount per share, or a scaled commission based on the size of your trade. This commission is applied when you buy a stock, AS WELL as when you sell it.

Now let's talk about Forex trading and how Forex works. The vast majority of Forex brokers will advertise in very big letters somewhere on their site that they do NOT charge commission. With the exception of a few brokers, the Forex market lets traders open and close positions with no commission at all.

So, it costs you nothing to trade. This of course begs the obvious question: “How do Forex brokers make money?” Here is where it gets tricky. It is true that there are no commissions in Forex trading, but the brokers are also not trading for you out of the goodness of their hearts. You can be sure that they come out on top, and in a big way. They charge you what's referred to as “Forex spreads”.

Before we understand what Forex spreads are and how they are calculated, it is important to understand one main principle about how the Forex market works. It is all based on supply and demand, just like any other market. If there is a higher demand for dollars, the value of the dollar will go up vs other currencies. This is precisely how Forex spreads are defined and calculated.

A Forex spread is the difference in price between what a Forex broker will buy the currency from you for and the price at which they will sell it. So, for example, if you are opening a position in which the base currency is dollars, and since there is no shortage in demand for dollars, the Forex spread on this transaction will almost always be smaller than a spread on a less common currency. Why?

This is again because of supply and demand. The broker will have no problem whatsoever selling off the dollars they just bought, so they do not need to charge you, the trader, a higher spread. Whereas, if the position's base currency was the Vietnamese Dong (yes, that is the name of the currency in Vietnam), the spreads will typically be higher.

Another characteristic Forex brokers take into account when calculating spreads is the type of account in which you are trading. Mini accounts are typically associated with higher spreads. This is of course because the broker needs to compensate the relatively low amount of capital being traded with a higher spread, so as to make their profit.

Now, that we established that as attractive as Forex trading is, it is not completely cost free, let's understand the difference between Forex spreads and stock market commissions. The primary difference is that in Forex, you are generally only charged a spread on one side of the transaction, the “buy” side. When you buy currency, that is when brokers generally make their profit by charging you a spread.

It is extremely crucial that traders understand how significant the spread is when choosing a broker. The difference one Forex pip can make in a broker's spread might be the difference between a successful Forex trader and a complete Forex failure.

Just to summarize, let's take a look at a concrete example of a spread and understand how it works exactly. Let's say we had a USD/CAD bid price of 120.00 (that is the price at which the broker is willing to BUY the USD) and an ask of 120.05 (the price at which the broker is willing to SELL the USD). In this case, the spread is equal to 0.05, or $0.0005, and that money goes straight into the broker's pockets.

There is so much more to be said about Forex trading spreads, such as whether a broker offers fixed or variable spreads, but you should now have a better understanding on how Forex brokers make their money.