What is a Spread in Forex Trading?

In the world of Forex trading, currency pairs are quoted with two distinct prices: the bid and ask prices.

The "bid" price represents the amount at which you can sell the base currency.

On the other hand, the "ask" price denotes the rate at which you can purchase the base currency.

The disparity between these two prices is commonly referred to as the spread, sometimes also known as the "bid/ask spread."

It's important to recognize that this spread serves as the primary source of income for "no commission" brokers in the Forex market.

Essentially, the spread functions as the fee for facilitating instantaneous transactions, which is why terms like "transaction cost" and "bid-ask spread" are often used interchangeably.

Rather than imposing a separate fee for executing trades, brokers incorporate the cost into the buying and selling prices of the currency pair you intend to trade.

From a business perspective, this approach is logical. Brokers offer a valuable service and need to generate revenue in the process.

Here's how they do it:

• They profit by selling the currency to you at a slightly higher price than what they paid to acquire it.

• Simultaneously, they make money by buying the currency from you at a slightly lower rate than what they will obtain when they resell it.

• This differential between buying and selling prices constitutes the spread.

To illustrate, consider the scenario where you are trying to sell your old iPhone to a store that specializes in buying used iPhones (even if it has just two rear cameras – not ideal!).

For the store to turn a profit, it must purchase your iPhone at a price lower than the amount for which it intends to sell it.

If the store can sell the iPhone for $500, then, in order to make any profit, the highest price it can offer you is $499.

This $1 difference represents the spread.

Therefore, when a broker touts "zero commissions" or "no commission," it's essential to understand that while there may not be a separate commission fee, you are still incurring a commission cost – it's simply embedded within the bid/ask spread.

How the Spread is Quantified in Forex Trading:

The spread in Forex trading is typically quantified in pips, which constitute the smallest unit of price movement within a currency pair.

For most currency pairs, a single pip equates to 0.0001.

For instance, if we consider a 2 pip spread for EUR/USD, the quote would be 1.1051/1.1053.

In cases involving currency pairs that include the Japanese yen, quotes are expressed with only 2 decimal places (unless fractional pips are involved, in which case it extends to 3 decimals).

For instance, USD/JPY might be quoted as 110.00/110.04, indicating a 4 pip spread.

Varieties of Spreads in Forex:

The types of spreads available on a trading platform are contingent on the specific Forex broker and their revenue model.

There are two primary categories of spreads:

• Fixed Spreads

• Variable Spreads (also known as "floating" spreads)

Understanding Fixed Spreads in Forex:

Fixed spreads remain constant regardless of prevailing market conditions. In simpler terms, whether the market exhibits high volatility akin to Kanye's moods or remains tranquil as a mouse, the spread remains unaltered—it stays fixed.

Brokers that operate under a market maker or "dealing desk" model typically offer fixed spreads.

Through the dealing desk model, the broker acquires sizable positions from their liquidity provider(s) and subsequently offers these positions in smaller increments to traders.

This approach means that the broker assumes the role of the counterparty in their clients' trades.

The presence of a dealing desk empowers Forex brokers to provide fixed spreads because it enables them to exercise control over the prices they present to their clientele.

Advantages of Trading with Fixed Spreads:

Opting for fixed spreads in trading presents several advantages. First and foremost, it requires a smaller initial capital outlay, making it an affordable option for traders with limited funds at their disposal.

Moreover, trading with fixed spreads enhances the predictability of transaction costs. Given that spreads remain constant, traders always have a clear understanding of the expenses associated with opening a trade.

Disadvantages of Trading with Fixed Spreads:

Nonetheless, there are certain drawbacks associated with trading using fixed spreads. Requotes can be a frequent occurrence when employing fixed spreads, primarily because pricing emanates from a single source—your chosen broker.

To put it in perspective, these requotes can be as recurrent as Instagram posts from the Kardashian sisters!

In situations where the Forex market experiences heightened volatility with rapidly fluctuating prices, fixed spreads can pose a challenge. The broker lacks the flexibility to widen the spread to accommodate the prevailing market conditions.

Consequently, if you attempt to initiate a trade at a specific price, the broker may "block" the trade and propose a new price. This results in what is commonly referred to as a "requote," wherein you are presented with a new price.

The requote notification will surface on your trading platform, informing you that the price has shifted and inquiring whether you are willing to accept the revised rate. More often than not, the offered price is less favorable than the one you originally requested.

Another issue that may arise is slippage. When market prices are in rapid motion, the broker may struggle to maintain a fixed spread consistently. As a result, the price at which you ultimately enter a trade can vary significantly from your intended entry price.

In a way, slippage resembles the experience of swiping right on Tinder, agreeing to meet up with an attractive individual for coffee, and then realizing that the person in front of you bears little resemblance to their profile photo.

Understanding Variable Spreads in Forex:

Variable spreads, as the name implies, exhibit constant fluctuations. In this context, variable spreads refer to the ever-changing disparity between the bid and ask prices of currency pairs.

Non-dealing desk brokers are the providers of variable spreads. These brokers source their currency pair pricing from multiple liquidity providers and relay these prices to traders without intermediary involvement from a dealing desk.

This approach leaves them with no control over the spreads, which instead widen or narrow in response to shifts in currency supply and demand, as well as fluctuations in overall market volatility.

Typically, spreads tend to widen during periods of economic data releases and in other instances when market liquidity diminishes, such as holidays or when unusual events occur (like the onset of a zombie apocalypse).

For instance, you might intend to purchase EURUSD with a 2-pip spread, but just as you're about to execute the trade, the U.S. unemployment report is released, causing the spread to swiftly expand to 20 pips.

Advantages of Trading With Variable Spreads:

Variable spreads offer the benefit of averting requote occurrences. This is due to the inherent variability of the spread, which adjusts to pricing shifts induced by prevailing market conditions.

(It's worth noting, however, that the absence of requotes does not eliminate the possibility of slippage.)

Furthermore, trading Forex with variable spreads fosters more transparent pricing, especially when considering that access to pricing from multiple liquidity providers usually results in improved pricing due to competitive forces at play.

Disadvantages of Trading With Variable Spreads:

Variable spreads may not be the best choice for scalpers, as the widened spreads can quickly erode any profits garnered by these traders.

Additionally, variable spreads are less favorable for news traders, as spreads may expand to such an extent that what initially appears to be a profitable opportunity can transform into an unprofitable one in the blink of an eye.

Fixed vs Variable Spreads: Making the Choice

The decision between fixed and variable spreads hinges on the specific requirements of the trader. There is no universal "better" option; it depends on individual preferences and trading styles.

Some traders may find fixed spreads more suitable, while others may prefer the offerings of variable spread brokers.

In a broad sense, traders with smaller accounts who engage in less frequent trading tend to benefit from fixed spread pricing. Conversely, traders with larger accounts who actively trade during peak market hours, when spreads are typically at their tightest, often find variable spreads more advantageous.

Traders who prioritize swift trade execution and wish to steer clear of requotes are typically inclined to opt for trading with variable spreads.

Understanding Spread Costs and Calculations:

Now that you comprehend what a spread is and are acquainted with the two types of spreads, it's crucial to grasp how spreads relate to actual transaction costs. The calculation is straightforward and necessitates just two pieces of information:

• The value per pip

• The number of lots being traded

Let's delve into an example to illustrate this concept:

In the provided quote, you can buy EURUSD at 1.35640 and sell EURUSD at 1.35626.

This implies that if you were to purchase EURUSD and immediately close the position, it would result in a loss of 1.4 pips.

To ascertain the total cost, you would multiply the cost per pip by the number of lots involved in the trade.

For instance, if you're trading mini lots (equivalent to 10,000 units), the value per pip is $1, resulting in a transaction cost of $1.40 to initiate this trade.

It's worth noting that the pip cost is linear, meaning that it scales proportionally with the size of your position. Consequently, if you increase your position size, the transaction cost, reflected in the spread, will also increase accordingly. For instance, if the spread amounts to 1.4 pips and you're trading 5 mini lots, your transaction cost would amount to $7.00.