Prices on currency exchange currency pairs are quoted as bid-offer spreads, the bid being the sell price and the offer being the buy cost. So, if the EUR / USD is quoted at 1.4256 / 1.4258, a trader desiring to go long ( buy ) would buy the currency pair at 1.4258, while a trader desiring to go short ( sell ) would sell the currency pair at 1.4256.
The difference between the 2 costs, in this case, is 2 pips, or 0.0002 ( a pip is generally measured as 0.0001 ).
Typically, the more liquid a currency exchange pair is, the smaller the bid / offer spread will be. The liquidity of a pair is decided by how many trades are happening on it, so that the most commonly traded pairs generally have the smallest bid-offer spreads.
How currency exchange providers make their cash
Foreign exchange is a market on which traders can trade commission-free. This means that currency exchange providers make their profits on the differences between the bid and offer costs.
In the case of the EUR / USD pair quoted at 1.4256 / 1.4258, a trader going long would buy the pair at 1.4258. The pair, now costed at 1.4256 in the market, would have to rise 3 pips for the trader to earn a profit one pip to 1.4257, a 2nd pip to 1.4258 ( the break-even point ), and a 3rd pip to 1.4259. The two-pip movement in which the trader breaks even is where the currency exchange provider makes its profit.
What is price shading?
Currency exchange providers generally add pips to the prices quoted to them by the banks to extend their margin. Price shading is when a currency exchange provider, believing that a particular currency is going to move in a certain direction, will add pips to one side of the currency quote. So if a currency exchange provider assumed the EUR / USD pair would rise, it may quote the pair at 1.4256 / 1.4260, instead of 1.4256 / 1.4258, meaning that a trader going long would have to buy the pair at 1.4260.
Accordingly, the currency pair would have to move 5 pips for the trader to earn a profit, and the four-pip movement in which the trader broke even would be the currency exchange provider’s profit.
Generally, if there are way more buyers than sellers of a currency pair, a provider will shade the buy side by adding pips to the offer cost. Likewise, if there are far more sellers than buyers of a currency pair, a provider will shade the sell side by adding pips to the bid cost.
Why it works
If there were 500 consumers and 500 sellers of a certain currency pair, and the foreign exchange provider had added one pip to each side of the inter-bank quote, the provider would make one pip for each trade ( or 1,000 pips ).
If there were 300 customers and 700 sellers, the provider would add 2 pips to the bid price and no pips to the offer cost.
So that the inter-bank rate for the EUR / USD pair is 1.4255 / 1.4256 and the broker quotes it at 1.4253 / 1.4256, meaning the sellers sell at 1.4253 while the buyers buy at 1.4256. As the amount of sellers in the market is higher than the number of buyers, the currency pair falls in value. The pair wants to fall by 2 pips for the sellers to break even ( from 1.4255 to 1.4253 ), and the foreign exchange provider makes those 2 pips in profit. That is 1,400 pips of profit for 1,000 traders.
The simplest way to use this to your advantage
To ascertain whether your forex provider is using price shading you would need to compare the quoted costs to those quoted by Reuters or Bloomberg, or create an account with 2 providers, one of them being a straight-through processing broker who will charge a commission instead of profit on the bid / offer spread.
If your provider’s costs are constantly biased to one side, it means that the majority of orders coming from retail patrons are coming from that side. Because the majority of retail investors are usually wrong, you might trade on the other side if the bias is on the purchase side, you might sell, and if the bias is on the sell side you might purchase.
Also, as these spreads drawback the majority by cutting into their profits ( remember, your forex pair wishes to cross the ask / buy spread to get to break even before you can turn a profit ), you will get advantages from not losing the shaded pips, fundamentally entering your position at a nicer price than the majority of investors.
When selecting a forex broker
Any broker that doesn’t charge a commission for forex trading will make its profit in the ask / buy spread; and it is the trader’s responsibility to compare different fx providers to underdant their commission structures and how they get paid.
A trader should choose a reputable provider based on the strength of the company, their history of service, any awards they have won and whether they are regulated by your country’s regulatory authority. A good forex provider will offer this information freely, along with transparent information about their spreads, accessible on their website or by phone.
As forex spreads can vary thanks to the levels of liquidity in the market, a good forex broker should pass narrow spreads in the underlying market on to clients, as well as having a maximum spread cap.