In the Forex Trading, What is a Spread?

What is spread in forex trading For each currency pair, forex brokers will provide you two separate prices: the bid and ask price.

June 14, 2022 - 10:35 AM 379 views

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For each currency pair, forex brokers will provide you two separate 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 purchased.

The spread is the difference between these two prices.

Also referred to as the "bid/ask spread."

Brokers who do not charge commissions rely on the spread to make money.

This spread represents the cost of enabling instantaneous transactions. This is why "transaction cost" and "bid-ask spread" are interchangeable terminology.

The cost of making a trade is included into the buy and sell price of the currency pair you want to exchange, rather than being charged separately.

This makes sense from a business aspect. The broker provides a service and must earn a profit in some way.

They profit by selling the currency to you for a higher price than they purchased for it.

They also profit by purchasing currency from you at a lower price than they would receive when they sell it.

The spread is the term for this discrepancy.

It will need to buy your iPhone at a lesser price than it would sell it for in order to earn a profit.

If it can sell the iPhone for $500, the maximum it can buy from you is $499 if it wants to earn any money.

The spread is the $1 difference.

When a broker says "zero commissions" or "no commission," this is misleading since you still pay a commission even if there is no separate commission cost.

It's simply a function of the bid/ask spread!


How Spread is measured in the Forex Trading

The spread is commonly expressed in pips, which is the smallest unit of a currency pair's price change.

One pip is equal to 0.0001 for most currency pairs.

1.1051/1.1053 is an example of a two-pip spread for EUR/USD.

The Japanese yen is quoted to just two decimal places (unless there are fractional pips, in which case it is quoted to three decimal places).

USD/JPY, for example, would be 110.00/110.04. This quote shows a 4 pip spread.

Types of Spreads in the Forex Market (FX)

The types of spreads you'll see on a trading platform are determined by the forex broker's business model.

Spreads are divided into two categories:

   1-Fixed 

     2-Variable (sometimes known as "floating") is a type of variable that cannot be changed.


Usually, fixed spreads are provided by forex brokers that functions as a “market maker” or “dealing desk models” whereas the variable spreads are provided by the forex brokers functioning as a “non-dealing desk model.”


In Forex, what are fixed spreads?

Fixed spreads remain constant no matter what the market conditions are at any one time. In other words, the spread is unaffected whether the market is erratic like Kanye's moods or quiet as a mouse. It does not change.

Brokers who operate on a market maker or "dealing desk" model offer fixed spreads.

The broker buys large positions from their liquidity provider(s) and offers them to traders in smaller sizes through a dealing desk.

This means that the broker is the counterparty to the trades of their clients.

Because they can control the prices they present to their clients, a forex broker with a dealing desk can offer set spreads.

Trading with Fixed Spreads – Advantages

Fixed spreads have lower capital requirements, making it a more affordable option for traders who don't have a lot of money to start with.

Trading with set spreads also simplifies the process of calculating transaction expenses.

Because spreads never fluctuate, you always know how much you'll spend when you open a transaction.

Trading with Fixed Spreads – Disadvantages

When trading with fixed spreads, requotes are common because pricing comes from a single source (your broker).

And by regularly, we mean almost as frequently as the Kardashian sisters' Instagram postings!

There can be moments when the currency market is extremely volatile, with prices fluctuating rapidly. Because spreads are fixed, the broker will not be able to modify the spread to market conditions.

If you try to enter a deal at a given price, the broker will "block" it and ask you to accept a different price. A new price will be "re-quoted" to you.

Your trading platform will display a requote notification informing you that the price has changed and asking if you are willing to accept it. It's almost always a lower price than the one you requested.

Another issue is slipping. When prices move quickly, the broker is unable to maintain a continuous fixed spread, and the ultimate amount you pay after initiating a transaction will be significantly different from the original entry price.

When you swipe right on Tinder and agree to meet up with that attractive gal or guy for coffee, you'll notice the person in front of you doesn't look anything like the photo.

In the Forex market, what are Variable Spreads?

Variable spreads, as the name implies, are continually changing. The difference between the bid and ask prices of currency pairs is continually shifting with varying spreads.

Non-dealing desk brokers provide variable spreads. Non-dealing desk brokers obtain currency pair pricing from a variety of liquidity providers and pass these prices on to traders without the use of a dealing desk.

This implies that they have no influence over the spreads. And spreads will broaden or narrow depending on currency supply and demand as well as overall market volatility.

Typically, spreads expand when economic data is released, as well as other times when market liquidity is low (like during holidays and when the zombie apocalypse begins).


For example, you might want to purchase EURUSD with a 2 pip spread, but just as you're about to press the buy button, the US unemployment report is issued, and the spread quickly widens to 20 pip!

Oh, and spreads may expand if Trump comments about the US dollar while still in office.

Advantages of Trading with Variable Spreads

Requotes aren't an issue with variable spreads. This is because the spread takes into account price movements due to market conditions.

However, just because you won't be requoted doesn't rule out the possibility of slippage.

Trading forex with variable spreads also gives more transparent pricing, especially when considering that having access to numerous liquidity providers usually equals better pricing due to competition.

Disadvantages of Trading with Variable Spreads

Scalpers should avoid variable spreads. The scalper's earnings will be soon eaten away by the wider spreads.
For news traders, variable spreads are just as terrible. Spreads can widen to the point where what appears to be a profitable trade becomes unprofitable in the blink of an eye.

Spread Costs and its Calculations

Now that you know what a spread is and the two sorts of spreads, there's one more thing you need to know...

The relationship between the spread and actual transaction costs.

It's really simple to compute and only requires two items:

1- The price of a pip

2- You're trading a certain quantity of lots.

Consider the following scenario...

You can buy EURUSD at 1.35640 and sell EURUSD at 1.35626 in the above quote.

This indicates that if you bought EURUSD and then immediately sold it, you would lose 1.4 pips.

You multiply the cost per pip by the number of lots you're trading to get the overall cost.

If you're trading small lots (10,000 units), the value per pip is $1, hence the cost of opening this trade is $1.40.

The cost of a pip is linear. This implies you'll have to multiply the cost per pip by the number of lots you're dealing with.

When you increase the size of your position, your transaction cost, which is reflected in the spread, will also grow.

If the spread is 1.4 pips and you're trading 5 micro lots, your transaction will cost $7.00.


Read More Article:

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