One of the most important points to know in forex trading is the spread. In this article we will be looking at it and what it means in forex trading.
The phrase comes from when forex brokers set 2 different price rates for currency pairs. These 2 different prices are known as the bid price and the ask price. So the ‘bid price’ is the rate for which you can sell the base currency and the ‘ask price’ is the rate for which you can purchase the base currency.
It’s good to remember then that for the base currency: the bid price is to sell and the ask price is to buy. The spread is the difference between both of these prices.
Forex brokers make money from the spread. Because instead of charging you a fee for making a trade, they will cover the fee through the currency pair sell and buy prices. So if a forex broker is saying that they offer ‘no commission,’ it’s not really accurate. Whilst there may not be a trading commission, in the end you pay the commission through the spread.
How to Measure the Spread in Forex Trading?
Like the word spread, you probably have also heard the term ‘pip’ mentioned in forex trading. This is because pips are used to measure the spread in forex. In a currency pair, a pip is the smallest unit of a price movement.
Generally, for currency pairs a single pip will be equal to 0.0001.
So, for instance, a 5 pip spread for GBP/USD is 1.1042/1.1047.
By counting the difference between the smallest units you can see the quote shows a difference of 5 pips.
Each forex broker will have their own version of spreads based on how the company works and how the broker makes commission.
There are 2 versions of spreads that brokers use. These are either variable or fixed ones.
Variable and Fixed Spreads
Let’s go through the differences of these 2 now:
- Variable Spreads, which can also be called ‘Floating Spreads’, are provided by brokers that act as a non-dealing desk type. Variable spreads are constantly shifting. For the ask and bid prices, the difference between the prices of the currency pairs are always moving. So the name ‘variable’ is quite fitting. Non-dealing desk brokers offer variable forex spreads, and they set the pricing of the currency pairs via multiple liquidity providers. These non-dealing desk providers will forward the prices directly to the trader. There is no need to have the involvement of a dealing desk. Ultimately this means that non-dealing desk brokers have zero control of the spreads. Instead, the supply and demand of currencies and the market outlook affects how they tighten or widen.
- Fixed Spreads are provided by brokers following a dealing desk method. For instance, they are not changeable and will remain the same, irrespective of market conditions and supply and demand. It’s good to remember that even if there is volatility in the market, the spread stays the same. It is not affected. Brokers offering fixed spreads use a dealing desk system unlike variable spreads which use a non-dealing desk. A dealing desk lets a broker purchase large positions via their liquidity provider. The brokers then offer these positions at reduced sizes to their traders. By offering smaller sizes, the broker becomes the counterpart to their trader’s trades.
Advantages & Disadvantages of the Spreads
There are various advantages and disadvantages to both types and it’s really up to you which one you prefer on forex trading.
For example fixed spreads are good if you have less capital to use as it remains fixed. You can always be sure what you will need to pay when calculating costs.
One thing you need to be aware of from fixed trading is slippage. When forex market prices are moving quickly the brokers cannot sustain a fixed spread. This means that after entering a trade, the price you end up with will be different to the original entry price.
For the variable one though, one advantage is that there is transparent pricing. This is due to the fact that non-desk models have access to many prices via multiple liquidity providers.
However the fact that variable spreads aren’t fixed can be an unpleasant surprise for traders. A spread can widen and change position so quickly that it may turn from profitable to unprofitable in seconds.
That’s why choosing between the spread types has advantages and disadvantages for each trader. It’s really best to do your own research and see what fits your trading needs. Every broker has different offers.