Forex trading is all about exchanging one currency for another with the motive of profiting. The fundamental of forex trading is a currency pair represented by, for example, EUR/USD. The left is called the “base,” and the right is the “quote” currency.
In the example, EUR is the base currency, and USD is the quote currency. The currency pairs are also known by other names, such as “bid” and “ask” price or base and “counter” currency. And the difference between them is called a “spread.”
The spread is the difference between the bid and asks prices of the underlying instrument. In Forex, it is usually expressed in pips- meaning one pip equals 0.0001. For USD/JPY, one pip equals 0.01.
Spread is crucial because it can influence the profits and losses made on forex trading. Lower or narrower spreads also increase the probability of making profits in forex trading.
Spreads also depict the liquidity in the market of the underlying asset. Wider spreads mean low liquidity while narrow spreads denote high liquidity. It is always good to trade in a market with high liquidity.
In general, spreads are typically wider when the market is volatile. So it would suggest that if volatility seems high, it may be time to look for opportunities to buy or sell the currency in question.
Spread is a method that most brokers use to earn money, as currency pairs often don’t incorporate commission while trading. As a result, the quoted buying price will always be higher than the quoted selling price and include an in-between market price. The spread is used by Forex traders to cover transaction costs such as commissions and spreads on different financial instruments like stocks, bonds, and commodities.
Before understanding how forex and CFD brokers make money, it is important to understand the types of brokers. The money made by brokers depends on their fee structure and the execution method used by them. Traders must acknowledge the trade execution method to understand the concept of spreads. However, spreads directly depend on the broker regardless of the trade execution method.
Market Maker: Brokers with dealing desks are also called market makers. Market makers can match the clients’ trading positions and can also take the other side of the trade themselves. Hence, apart from the spread and commission, a market maker can also make revenue from the losses booked by the traders.
Spread is always the major source of revenue for forex and CFD brokers. A market maker generally offers a narrower spread than ECN/STP brokers but there can be exceptions.
Brokers with no dealing desks do not take part in trade orders placed by the clients. They pass on the trade orders to liquidity providers where the trade orders are matched through the exchange.
STP: In Straight Through Processing (STP) method, the trade orders are passed directly to a certain liquidity provider. Buying and selling are done through the same liquidity provider. A broker can incur additional spread over the spread charged by the liquidity provider.
ECN: Brokers that use Electronic Communication Networks (ECN) for trade execution pass the orders placed by clients to multiple liquidity providers. The orders are executed with the one that offers the best pricing. Buying and selling can be done through different liquidity providers and hence the spread is reduced. A broker can incur addition spread or trading commission to offer ECN execution.
For ECN/STP brokers, the orders placed by the clients are passed to the broker which is forwarded to the exchange directly. The exchange or liquidity provider will also incur a spread. However, this spread at the liquidity provider will be lower than the spread incurred by the STP/ECN broker. So the difference between the spread at the liquidity provider and the one incurred by the broker is the revenue for the broker.
Some of the most common currency pairs include EUR/USD, USD/JPY, GBP/USD, and USD/CHF, wherein USD, EUR, JPY, GBP, and CHF stand for US dollar, Euro, and Japanese yen, British pound, and Swiss franc respectively.
Pip or percentage in point is the unit for measuring the spread and is the smallest price movement up to the fourth decimal for most currencies, excluding JPY, for which it includes up to two decimals.
Wider spreads in the price of an underlying asset represent high volatility and low liquidity. On the other hand, a lower Spread indicates high liquidity and low volatility. Therefore, a tighter Spread would include a smaller Spread cost while trading. Moreover, the spread is either fixed or variable and varies once the bid and ask price change.
Eventually, the spreads will depend on the broker chosen by the clients. Hence it is very important to check and compare the spread and commission incurred by the broker and their trade execution method.
, For example, , Suppose the spread for EUR/USD is 1 pip at a broker that uses STP/ECN method for order execution. The liquidity provider has the spread of 0.1 pip, then the remaining 0.9 pip will be the revenue for the broker. If a standard lot is traded, in this example, the revenue for the broker will be $9.
For example, a market maker does not pass on the trade orders to liquidity providers. For such brokers, the spread will be directly the source of revenue the broker. Additionally, if they have taken the opposite side of the trade themselves, they will earn revenue if the trader faces a loss. A market maker will face a loss if profits are booked by the trader.
For example, broker “requotes” constantly occur with Fixed Spreads. Moreover, the broker can’t widen the spread during volatile market conditions or rapid price changes. Thus, under most requote circumstances, the price is worse than the order. Another disadvantage of Fixed Spread is Slippage, i.e., a broker’s inability to maintain a fee after the trader enters as it differs from the entry price.
Likewise, scalpers won’t find Variable Spread ideal as a widened scenario can significantly diminish profits and even enlarge enough to become unprofitable. Therefore, the spread should depend on market scenarios, and traders should look out for a narrow spread in the market.
The buy and sell prices of a currency pair are used for Spread calculation. The amount is paid upfront during Spread betting or CFD trading. Also, the commission is paid while trading share CFDs upon entry and exit. Therefore, traders get a better value with a tighter Spread.
Low or narrow spread will benefit the trader in 3 ways:
Let us understand the implication of spreads on trading positions with the help of an example.
In this example, we will open a long position on 1 standard lot (100,000 units) of EUR/USD currency pair. The prices of the EUR/USD pair have been taken as 1.2100/1.2102 and the leverage is 1:20.
Here, it can be noted that the spread is 2 pips.
For opening the long position of 1 standard lot, traders will require:
100,000 X 1.2102 X 1/20 = $6051
The profits can only be booked once the bid price moves above the asking price that was used while opening the positions. In other words, profits can only be booked after the price moves more than the spread.
In this example, if prices are increased by 5 pips the profits will be $30 as the third pip movement will initiate the profits. If the spreads were 10 pips in this example, the trader would still face a loss of $50 after 5 pip movement in a favourable direction.
Hence, it can be concluded that the wider spread will restrict traders from gaining profits. This will reduce the probability of making profits on trading positions. Additionally, it will also reduce the profits and increase the losses made on a trading position.
Traders and large liquidity providers should look out for high spread because the outcome of a news event on the bid and ask price is unknown. Moreover, the market timing is uncertain, and sporadic economic calendars shake prices rapidly. The reason for having a high Spread is to offset the risk. The time of the day and volatility are other significant factors driving forex spreads.
, For example, , Euro and Asia trade open at morning and night hours, respectively. Therefore, if the former is booked during the latter’s session, it will create a higher or broader Spread and even become a costlier affair than if the booking happened during the Euro session. The reason is the lack of traders resulting in diminished liquidity. However, the scenario would not exist during a regular trading session.
A non-liquid market means more miniature trading, and therefore, brokers broaden the spread to manage the risk of loss if they reach a position. Similarly, extreme volatility is a stage wherein the fluctuation of exchange rates is wild. Therefore, forex brokers avoid the risk of loss under event-driven volatility periods by making the spread wider.
Furthermore, dramatic Spread widening can lead to margin call or liquidation. A margin call refers to a scenario wherein the trader can no longer avail of free margin. Therefore, leveraging the limit of the account is the best method of safeguarding against a widening Spread. Optionally, you can even hold on to Spread-widening until it becomes tighter or narrowed.
Traders receive margin call notifications whenever the account value diminishes below 100% of the margin value. At this point, a trader can no longer meet the trading requirements, and all positions liquidate whenever the margin value is below 50%. The size of forex trade is often greater than shares. So, it is essential to decide the forex leverage and positioning size.
If you’re looking to start forex trading, this ultimate guide (hyperlink) is excellent for beginners.
Choose favorable trading hours
As you get more experienced with forex trading, you will notice that particular times of the day are more favourable for forex trading. Why? Because when different forex markets (such as Asian or American) overlap, more traders are bidding on currency pairs.
The spreads tend to become wider when the concerned regions in a currency pair are inactive. For example, the London session is active from 8:00 to 16:00 (GMT) while the New York Session is active from 13:00 to 22:00 GMT. This means that both the London and New York session overlap from 13:00 to 16:00 GMT. At this time, the liquidity will be highest for EUR/USD currency pair and the spreads will be the lowest.
As the number of players increases, the demand created by buyers and sellers also increases. During those times, market makers often lower their spread to attract more traders. In short, trade during those hours when the liquidity is high or spreads are low.
Choose major currencies
You will notice that most traded currency pairs usually have a lower spread.
, For example, , GBP/USD or EUR/USD have most often very low bid-ask spread. But if you choose to trade with exotic pairs like AUD/MXN or EUR/TRY, you may find broader spreads because there are a limited number of forex traders dealing with these pairs. That also means lower liquidity and more risk. So until and unless you’re a pro, stick with major currency pairs.
In addition, traders should have an eye on the factors that influence the forex spreads, such as time of the day, trading platform, market volatility, important events (economic/financial news), etc. Also, remember to trade with major currency pairs and avoid exotic spreads which have larger spreads.
In forex trading, the prices for buying and selling each currency in return for others are different. The difference between the buy and sell price is called spread. Each currency pair has a different spread that increases or decreases depending on market conditions.
In forex, a spread of 0.3 means that the difference between the bid and ask price is 0.00003. 1 pip is 4th place after decimal or 1/100 of 1%. profit, loss, spread, and other price movements are measured in pips.
No, Higher or wider spread means more difference in the bid and ask price of the currency pair. If the spreads are high, traders need to pay more and there will be a lesser probability of making profits on the trading positions.
In forex trading, the spreads on each currency pair will be different. It depends on liquidity in the market and several other market conditions. The average spread on EUR/USD among FCA-regulated brokers in the UK is 0.8 pips.
No, spread is measured in pips. Spread is the difference between bid and ask price of an underlying instrument. A pip or percentage in points is the fourth decimal unit of the prices. Pip is used to measure spread.