For a currency pair, forex brokers will provide you with two prices: the bid and ask price.
The “bid” is the price at which the base currency can be SOLD.
The “ask” is the price at which the base currency can be BOUGHT
The spread is the difference between these two prices.
Also referred to as the “bid/ask spread.” The spread is how “no commission” brokers profit. This spread is the cost of delivering instant transaction processing. As a result, the words “transaction cost” and “bid-ask spread” are sometimes used interchangeably. Instead of imposing a separate fee for each trade, the cost is incorporated into the buy and sell prices of the currency pair you wish to exchange. This makes sense from a business aspect. The broker provides a service and must make a profit in some way.
- They make money by selling the currency to you for more than they paid to buy it.
- And they also make money by buying the currency from you for less than they will receive when they sell it.
- This difference is called the spread.
It’s the same as attempting to sell your old iPhone to a store that buys used iPhones.
To earn a profit, it must purchase your iPhone at a cheaper price than it would sell it for. If it can sell the iPhone for $500, the maximum it can buy from you and still make money is $499.
The spread is that $1 difference. When a broker says “zero commissions” or “no commission,” this is deceptive since you still pay a commission even if there is no separate commission cost.
How Is the Spread Calculated in Forex Trading?
The spread is often measured in pips, which is the smallest unit of a currency pair’s price movement.
One pip is equal to 0.0001 for the majority of currency pairs.
1.1051/1.1053 is an example of a 2 pip spread for EUR/USD.
Currency pairs involving the Japanese yen are stated to two decimal places (unless there are fractional pips, in which case three decimals are used).
For example, the USD/JPY rate is 110.00/110.04. This quote shows a 4 pip spread.
What Type of Spreads are in Forex?
The spreads you’ll see on a trading platform are determined by the forex broker and how they make money.
Spreads are classified into two types:
1. Fixed
2. Variable (Floating)
Fixed spreads are typically given by market makers or “dealing desk” brokers, whereas variable spreads are typically offered by non-dealing desk brokers.
What are Fixed Spreads?
Fixed spreads remain constant regardless of market conditions at any particular time. In other words, the spread is unaffected by whether the market is erratic or as quiet as a mouse. It remains the same. Brokers that function as market makers or “dealing desks” provide fixed spreads.
Using a dealing desk, the broker purchases large positions from their liquidity provider(s) and sells them to traders in smaller sizes. This means that the broker serves as the counterparty to the trades of their clients. Because a dealing desk allows the forex broker to control the prices displayed to its clients, they can offer set spreads.
What Are the Benefits of Using Fixed Spreads?
Fixed spreads feature lower capital requirements, making it a more affordable option for traders who don’t have a lot of money to start trading with.
Trading with set spreads also improves the predictability of computing transaction costs.
Because spreads never fluctuate, you always know what you’ll pay when you open a trade.
What Are the Disadvantages of Using Fixed Spreads?
Requotes are common when trading with fixed spreads because pricing is provided only by your broker. There will be instances when the forex market is volatile and prices change quickly. Because spreads are set, the broker cannot extend the spread to reflect current market conditions.
If you attempt to enter a deal at a specified price, the broker will “block” the order and request that you accept a different price. A new price will be “re-quoted” to you. The requote notification will show on your trading platform, informing you that the price has changed and asking you whether you are happy to accept the new price.
Another issue is Slippage. When prices move quickly, the broker is unable to maintain a stable fixed spread, and the price you eventually wind up at after placing a transaction will be significantly different from the original entry price.
Variable Spreads in Forex
Variable spreads, as the name implies, are always changing. The difference between the bid and ask prices of currency pairs fluctuates with varied spreads. Non-dealing desk brokers provide variable spreads. Non-dealing desk brokers obtain currency pair pricing from numerous liquidity providers and pass these prices on to traders without the involvement of a dealing desk.
This indicates that they have no influence over the spreads. And spreads will broaden or contract dependent on currency supply and demand as well as overall market volatility. Spreads typically widen during economic data releases and other times when market liquidity is low.
What Are the Benefits of Trading Variable Spreads?
Variable spreads remove the need for requotes. This is because the spread reflects price variations caused by market conditions.
(However, just because you will not be requoted does not imply you will not have slippage.)
Trading forex with variable spreads also gives more transparent pricing, especially as having access to quotes from different liquidity providers usually means better pricing due to competition.
What Are the Disadvantages of Trading Variable Spreads?
Scalpers should avoid variable spreads. The widening spreads can soon eat away any scalper earnings.
Variable spreads are equally detrimental to news traders. Spreads can spread so much that what appears to be a profitable trade can quickly transform into an unprofitable trade.
Fixed vs Variable Spreads: Which is Better?
The choice between fixed and variable spreads is determined by the trader’s requirements.
Fixed spread brokers may be preferable to variable spread brokers for some traders. Other traders may experience the opposite effect.
Fixed spread pricing is generally advantageous to traders with smaller accounts and who trade less frequently.
Variable spreads will also help traders with larger accounts that trade regularly during peak market hours (when spreads are at their narrowest). Traders who need fast trade execution and wish to avoid requotes should use variable spreads.
Spread Calculations and Cost
Now that you understand what a spread is and the two sorts of spreads, you need to know one more thing…
The spread’s connection to actual transaction costs.
It’s a simple calculation that requires only two items:
The price per pip
The number of lots in which you trade
Consider the following example:
You can buy EURUSD for 1.35640 and sell EURUSD at 1.35626 in the quote on the right. This indicates that if you buy EURUSD and then immediately sell it, you will lose 1.4 pips.
To calculate the overall cost, multiply the cost per pip by the number of lots traded.
Hence, if you’re trading small lots (10,000 units), the value per pip is $1, so the transaction cost to open this trade is $1.40.
The cost of pip is linear. This implies multiplying the cost per pip by the number of lots you are trading.
When you increase the size of your position, your transaction cost rises, which is reflected in the spread.
For instance, if the spread is 1.4 pips and you trade 5 micro lots, your transaction cost is $7.00.
Next Lesson: Types of Forex Orders
