One way of looking at the general structure of any Forex trade is that all trades are conducted through middlemen who charge for their services. This charge, or the difference between the bidding price and the asking price for a trade, is called "the spread. The Forex market has always been virtual and functions more like the over-the-counter market for smaller stocks, where trades are facilitated by specialists called market-makers.
The buyer may be in London and the seller may be in Tokyo. The specialist, one of several who facilitates a particular currency trade, may even be in a third city. His responsibilities are to assure an orderly flow of buy and sell orders for those currencies. This involves finding a seller for every buyer and vice versa. In practice, the specialist's work involves some degree of risk. It can happen, for example, that the specialist accepts a bid or buy order at a given price, but before he finds a seller, the currency's value increases.
He is still responsible for filling the accepted buy order and may have to accept a sell order that is higher than the buy order he has committed to fill. In most cases, the change in value will be slight and he will still make a profit. But as a result of accepting the risk of a loss and facilitating the trade, the market maker always retains a part of every trade. The portion he retains is the spread.
Every Forex trade involves two currencies called a " currency pair. At a given time, GBP may be worth 1. You may believe the GBP will rise against the dollar, so you buy at the asking price. But the asking price won't be exactly 1. Meanwhile, the seller on the other side of the trade won't receive the full 1. The difference between the bid and ask prices -- in this instance 0. That's what the specialist keeps for taking the risk and facilitating the trade. Using our example above, the spread of 0.
Currency trades on the Forex typically involve larger amounts of money. But the average trade is much larger, around 1 million GBP.
Updated April 27, Avoid buying or selling thinly traded currencies. If you trade a thinly traded currency pair, there may be only a few market makers to accept the trade and, reflecting the lessened competition, they will maintain a wider spread.More...