Spread in Forex Trading – What is it?

 

In this article we’ll be looking at it what it is exactly and how you can use it in forex trading.

What Is The Spread?

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 between the bid and the ask 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 Is Spread Calculated?

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 types of spread 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.

 

What Does High Spread Mean In Forex?

A high spread in forex occurs when there’s a big variation between the bid and ask price. This normally happens in the forex market due to 2 reasons:

• There’s been high volatility in the market due to a big news event
• Low liquidity

Liquidity is the measure of how active a financial market is. Low liquidity normally occurs during out-of-hours trading, as liquidity is measured by the number of active traders in the forex market, and the total trading volume.

Luckily, because the forex market is international and there are millions of investors trading 24 hours each day Monday to Friday, the liquidity is normally high.

However, when international financial centres (depending on their time zone) open and close during the day, there may be a slight liquidity fluctuation. This affects the spread and can cause it to become higher.

Normally though, a high spread occurs because of an explosive news event that has shocked the market. This could be political events, election results, or referendum outcomes such as Brexit.

For instance, the United States Presidential Elections are likely to affect the EUR/USD pairing, and Brexit caused a lot of price volatility for the GBP/EUR.

This volatility causes price uncertainty in the market, so brokers will increase their spread costs to protect profits.

So if you’re a trader, a high forex spread is not great news because it means that you’ll have to pay more commissions.

 

How To Minimise and Manage The Spread

There are a few ways to minimise and manage the spread cost when trading.

First of all, it’s best if you trade during the trading hours that are most favourable to you. This would be during high liquidity hours, when there’s many sellers and buyers active in the market.

The more active the market, the more demand there is on certain currency pairs, so many forex brokers will tighten their spreads as a result.

For instance, imagine it’s Monday afternoon, there are many investors buying/selling in the EUR/USD currency pair.

Many brokers will adjust and narrow (tighten) their spreads in relation to the business demand. This means that the difference between the bid and ask price is reduced, and the spread is smaller.

Another way to minimise the forex spread cost is by focusing on the major currencies. That’s because many brokers are competing for business when traders buy and sell the ‘major’ currency pairs.

For example, the currency pair of GBP/USD is very popular, so spreads offered will be more competitive.

If you decide to trade on a thinly traded or ‘exotic’ currency pair, for example EUR/HUF, there are less people wanting to buy and sell that pair. As a result, that currency pair will have a higher (wider) spread, as there is less trading competition.

Last of all, always choose a reputable and regulated trading platform. Many unregulated brokers manipulate prices, so using a regulated broker is a good way to avoid that risk.

A regulated trading platform will clearly show their estimated forex spread and whether they charge commission or not. That way you can figure out up front what kind of spread and position costs you’ll be facing.

 

Conclusion

With so many differences between the spread types, it’s important that traders know the advantages and disadvantages of each.

We’d recommend that you compile your own research so you can find which spread type fits your trading needs the best.

You need to ask yourself whether a variable or a fixed spread suits your trading style better? For instance, some traders may find that using a variable spread is better than using fixed spread broker. The reverse can also be applied for other types of traders.

Usually though, it’s the traders that trade less frequently or have smaller accounts that’ll benefit more from a fixed spread.

Whereas for traders with bigger account who often trade, they’d benefit from a variable spread type. Especially if they trade during peak trading hours when the spreads are at their tightest.

That’s why you need to consider which type of forex spread would fit nicely with your account situation.

Every broker has different spread offers available so it’s worth checking what options are available. Offers can change periodically based on the market demand. 

 

To learn more about forex trading click here.