Spread in the foreign exchange markets is the difference between the “buy” and “sell” rates.
In case you want to sell the base currency, it is called “bid” price and if you want to buy the base currency, it is called “ask” price.
Also known as the “bid/ask spread“.
The value of the spread depends on the specific currency pair, the amount of the transaction, the state of the market, and other considerations.
The spread ranges from almost 0 to 10 – 20, and sometimes 100 or more pips.
Most forex brokers do not have commissions for currency trading and so the spread is practically the only cost of trading on the Forex market, excluding swaps.
The brokers decide how different the two prices should be when they offer you a quote.
They will make a quote for the bid price a little bit higher than what they paid for it. But the final bid/ask spread depends on every broker and the difference is usually just a few pips.
Therefore, the higher the turnover of the trader with his trading, the more the broker earns.
Let’s give you an example related to the 21st century.
You have a Playstation 4, but they have already released the new Playstation 5. You want to sell your old one and buy the new one.
If you want to sell your old PlayStation, you will go to a second-hand shop.
The owner decides how much he can sell your PlayStation to his clients.
Let’s say the price he will sell your PlayStation to his clients will be $150.
He should buy it from you for no more than $149.
That difference of $1 is the spread.
That’s how Forex brokers work as well.
How is the Spread in Forex Trading Measured?
The spread is usually measured in pips.
A pip is the smallest unit of the price movement of a currency pair.
For most currency pairs, one pip is equal to 0.0001.
Example:
The quote for the currency pair GBP / USD is 1.3550 /53. It means that the customer can sell euros at a price of 1.3550 dollars for 1 pound or buy pounds at a price of 1.3553 dollars for 1 pound.
This quote indicates a spread of 3 pips.
What Types of Spreads are in Forex?
There are two types of spreads that you can see on your trading platform, depending on which broker you choose.
Two types of spreads:
- Fixed
- Variable
For example, if you prefer having fixed spreads, you need to choose Dealing Desk Broker.
But if you rather have tighter spreads and pay a commission, you will choose No Dealing Desk Broker.
What are Fixed Spreads in Forex?
The fixed spread represents a constant difference between the buy and sell rates, regardless of the market situation. Even when the market is volatile, the spread is not affected.
Dealing Desk brokers are setting both the bid and ask price and the traders use these set terms.
They make money by buying at lower prices and selling at higher prices, and by taking advantage of the spreads between the bid and ask price.
In most cases, dealing desk brokers keep trades safely within their own liquidity pools and do not require external liquidity providers.
They buy from their liquidity provider and offer these positions to their clients.
This makes them the counterparty to their clients’ trades.
Offering their clients’ fixed spreads means that they are able to control the prices they display to their clients.
What are the Advantages of Trading With Fixed Spreads?
Smaller capital requirements are what attract new traders who don’t have a lot of money to start with.
Plus, when you are trading with fixed spreads, you know what to expect as your transaction cost.
What are the Disadvantages of Trading With Fixed Spreads?
Some people believe that this type of brokerage takes advantage of the trader because they control the prices at which orders are filled, but many traders prefer these fixed spreads.
Since DD brokers use artificial quotes, their clients do not see the real interbank market rates.
Be prepared for a scenario when you order to close a trade at a certain price and you get a message asking you to accept a new price. It is always worse than the one you ordered.
Why does this happen?
Sometimes the forex market can be really volatile and the prices will be changing faster than the speed of the light.
Since spreads are fixed, the broker won’t be able to widen the spread to adjust for current market conditions.
Then the broker will “block” the trade and will give you a re-quote with a new price.
It stinks, we know! But there is no playing safe even with fixed spreads.
What’s more is that in case of slippage, you can end with a price that is totally different from the intended entry price.
It happens when the broker is unable to consistently maintain a fixed spread, because of the movements of the prices on the real market.
The disappointment of slippage is almost similar to when you order online a wood table for your dining room and in the end, the package you receive contains 2 plastic chairs instead of the table.
What are Variable Spreads in Forex?
Variable spreads allow the difference between the bid and the ask price to be changing at any given moment.
Non-dealing desk brokers offer such variable spreads.
They work with multiple liquidity providers to give their clients variable spreads and to match traders with other traders who would like to take the other side of a trade.
Since they have no control over the spreads, the difference of bid and ask price can widen or tighten based on the supply and demand of currencies and the overall market volatility.
Wide Forex Broker Spread
You can experience a situation when variable spread brokers increase the spread significantly during a volatile market in order to increase profits, highlighting the unpredictability of the market.
Many forex brokers practice the variable spread rule exclusively, believing that a fixed spread can only be kept in a quiet and calm market.
What are the Advantages of Trading With Variable Spreads?
The floating spread also has its advantages, such as the fact that in a low volatile market it can fall by a lot (0.5-2 points), while the fixed spread remains constant even during low volatile market conditions, they can be higher by 3-5 pips.
The wider spread of certain pairs does not necessarily mean that they are worse for trading than other currency pairs. Conversely, a narrower spread does not necessarily mean that trading with the respective currency pair is preferable.
It is very important at what value of currency pairs a position is opened and closed.
The chance to open a bottom position for the day and close a position at the climax is less than 1%.
Traders, especially those who use small time frames, should be careful whether the volatility of a particular currency pair at a given time is high enough to be worth trading, given the spread.
The fact that variable spreads eliminate having requotes from your broker, it doesn’t mean that you can’t experience slippage.
What are the Disadvantages of Trading With Variable Spreads?
In practice, almost every day there are moments with sharp fluctuations in prices, where the spread can reach 50 points.
This not only creates inconvenience for trading but can also be detrimental to your deposit.
That’s why variable spread can be really dangerous for new traders.
When you just thought that something looks profitable, it could turn into unprofitable, because of how wide the spread became.
Fixed vs Variable Spreads: Which is Better?
Whether you choose fixed or variable spreads depend completely on your needs as a trader.
Traders who have smaller accounts and who trade less frequently will use fixed spread pricing.
Traders with larger accounts who trade frequently during peak market hours (when spreads are the tightest) will prefer variable spreads.
If you want a fast trade execution and NO requotes, you will trade with variable spreads.
Spread Costs and Calculations
In order to know how much your transaction will cost, you need to calculate two things:
- The value per pip
- The number of lots you’re trading
Let’s look at an example
You can buy EURUSD at 1.17959 and sell EURUSD at 1.17950.
This means if you were to buy EURUSD and then immediately close it, it would result in a loss of 0.9 pips.
To figure out the total cost, you would multiply the cost per pip by the number of lots you’re trading.
So if you’re trading mini lots (10,000 units), the value per pip is $1, so your transaction cost would be $0.90 to open this trade.
Spread Cost Calculation:
Let’s take another example: The spread is 1.4 pips and you’re trading 5 mini lots, then your transaction cost is $7.00.
5 mini lots = 10 000 x 5
50 000 x 0.00014 = $7.00
When you multiply the cost per pip by the number of lots you are trading, you will get your spread cost.
Don’t forget that they are related, if you increase your position size, your transaction cost will rise as well.
