What is a Spread in Forex Trading?

For a currency pair, forex brokers will provide you 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 known as “bid / ask spread”. Spreads are the profits of brokers with no fees. This spread represents the cost of providing transaction immediacy. Therefore, the terms “transaction cost” and “bidasque spread” are sometimes used interchangeably.

Instead than 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 profit by selling the currency to you for more than they paid for it, and they profit by purchasing the currency from you for less than they will receive when they sell it. This discrepancy is referred to as the spread.

It's the same as attempting to sell your old iPhone to a store that sells used iPhones. (Can you imagine a smartphone with only two rear cameras？ Yuck!)

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.

So when a broker says “zero commissions” or “no commission,” it's deceptive since you still pay a commission even though there is no separate commission cost.

It's simply baked into the bid/ask spread!

How is the Spread in Forex Trading Measured？

The spread is often measured in pips, which is the smallest unit of a currency pair's price fluctuation.

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 Types of Spreads are in Forex？

The spreads you see on trading platforms are determined by the forex brokers and how they make money.

Spreads are classified into two sorts.

Fixed spreads are typically given by brokers who operate under the market maker or “dealing desk” model, whereas variable spreads are typically offered by brokers who operate under the “non-dealing desk” model.

What are Fixed Spreads in Forex？

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 like Kanye's moods 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 increments.

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 Advantages of Trading With Fixed Spreads？

Because fixed spreads have lower capital requirements, trading with fixed spreads is a less expensive 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're going to pay when you open a transaction.

What are the Disadvantages of Trading With Fixed Spreads？

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

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

There can 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.

As a result, if you try to enter a deal at a given price, the broker will “block” the order and ask you to 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. It's almost always a lower price than the one you requested.

Another issue is slippage. When prices move quickly, the broker is unable to maintain a stable spread on a consistent basis, and the price at which you eventually end up after initiating a transaction will be significantly different from the original entry price.

Slippage is akin to when you swipe right on Tinder and agree to meet up with that attractive gal or guy for coffee only to learn the person in front of you does not resemble the photo.

What are Variable Spreads in Forex？

Variable spreads, as the name implies, are always shifting. The spread 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 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 (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 click buy, the US unemployment report is issued, and the spread quickly widens to 20 pip!

Oh, and spreads may grow if Trump tweets about the US currency at random while still President.

What are the Advantages of Trading With Variable Spreads？

Variable spreads remove the need for requotes. This is due to the spread's volatility accounting for 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 With Variable Spreads？

Scalpers should avoid variable spreads. The widening spreads can swiftly eat away at any profits made by the scalper.

Variable spreads are equally detrimental to news traders. Spreads can widen to the point where what appears to be a profitable trade can transform into an unprofitable trade in the blink of an eye.

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. The opposite may be true for other traders.

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 that need fast trade execution and wish to avoid requotes should use variable spreads.

Spread Costs and Calculations

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

The spread's relationship to actual transaction costs.

It's really simple to compute, and all you need are two things:

· The price per pip.

· The number of lots in which you are trading

Let's have a look at an example...

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

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, which is reflected in the spread, rises as well.

For instance, if the spread is 1.4 pips and you trade 5 micro lots, your transaction cost is $7.00.