In the business of trading currencies, investors trade one currency for another. Prices of currencies in the foreign exchange market are quoted in terms of their value in another currency. And, so as to convey this information without difficulties, currencies are often quoted in pairs, for example, EUR/USD.
The first part of the quote is referred to as the base currency while the second part is referred to as the counter or quote currency (base/quote). For instance, if it took 1.1340 euros to purchase one dollar, then the expression EUR/USD would equal 1.1340/1 or 1.1340. In this case, the euro would be the base currency while the United States Dollar would be the quote or counter currency.
After knowing how the prices of currencies of different currencies are quoted in the foreign exchange market, let us now examine how spreads are determined. In Forex trading, there are normally two prices of currencies: the bid prices and ask prices. The bid price refers to the amount which the Forex market maker is ready to give to purchase the base currency (the euro in the example above) in exchange for the quote currency (the United States dollar) while the ask price refers to the amount which the Forex market maker is ready to use to sell the base currency in exchange for the quote currency. The difference between the bid price and the ask price is what is referred to as the spread.
FX brokerage firms usually receive commission for their services in terms of the spread. For instance, the current exchange rate is 1.1340 for EUR/USD. And, if a trader wants to buy the pair, he may be quoted 1.1341, and if a trader wants to sell the pair, he may be quoted 1.1339. In this case, the spread for the pair is two pips. It is of essence to note that spreads normally stay around the actual price; therefore, you get either of the ends of the spread depending on whether you buy or sell.
Forex brokerage firms usually offer either fixed spreads or variable spreads. As their name suggest, fixed spreads do not change, regardless of the conditions of the market. On the other hand, variable spreads keep going up and down depending on the conditions of the market.