What is the Spread in Forex?

What is the Spread?

EURUSDQuote-spreadThe spread is the difference between the bid price and the ask price in forex. To understand the spread, certain concepts have to be understood by the trader…

In the offline forex business, we have currency exchangers and Bureau de Change operators who are available to exchange currencies for business transactions and for travelers. Take for example, the case of a US citizen wanting to visit a European country. The US Dollar is not recognized as legal tender for use in a country like Portugal. So a holidaying US tourist will need to exchange his US Dollars for the legal tender used in Portugal, which is the Euro.

When the exchange is done from US Dollars to Euro, the tourist will be offered a rate. After his holiday, that tourist will need to exchange the unspent Euros in his possession for US Dollars, since the Euro is not recognized as the legal tender in the US. This will be done at a rate that will be different from the original exchange rate. The difference in the exchange rate when converting from the base currency to the other currency is the spread. Usually, a currency exchanger will purchase a foreign currency at a lower price, and resell that currency for a higher price, thus profiting from the difference.

The same principle holds sway in the online spot forex market. All currency pairs are quoted with 2 prices as shown below:

spread

The price on the left is the bid price, which is the price that the dealer is prepared to buy a currency from a trader, and the price on the right is the ask price, which is the price that the dealer is prepared to sell a currency to the trader. So a trader will buy at the ask price, and sell at the bid price. The difference between the bid price and the ask price is the spread, and is measured in percentage interest points, or PIPs.

Different Types of Spreads

Spreads are of two types:

a)    Fixed

b)    Variable

Fixed spreads are a feature of market maker retail platforms such as these forex brokers here. In this setup, the market maker fixes prices for positions that will be acquired by their retail clients, and therefore the spreads tend to be fixed irrespective of the conditions in the market.

On the other hand, variable spreads are a feature of Electronic Communication Network (ECN) platforms in which the order processing mechanism is a straight-through processing (STP) method. Pricing is obtained from several major liquidity providers and fed straight to the traders without passing through a dealing desk. This provides a situation where spreads not only differ from one liquidity provider to another, but actually adjust according to the demand and supply mechanism at work in the market for the currency pair in question. So it is possible to have a spread of 3 pips on a currency, and a second later, it climbs to as much as 10 pips. This is seen especially on news trades that will cause high volatility in the market.

There is no advantage of one spread type over another. It all depends on the choice the trader makes in choosing a broker type.

Implications of the Spread

What are the implications of the spread and what is the monetary value of the spread?

On the traders’ end, the spread is part of the cost that is incurred in executing trading transactions. Different currency pairs and assets have different spreads. Generally speaking, the more liquid a currency pair is, the lower the spread. Liquidity is a function of how many active traders from all over the world are actively trading the currency pair. Liquid pairs have lower spreads, but a more limited range of movement. Illiquid pairs tend to have larger spreads and more range of movement.

On the broker’s side of the equation, the spread is the compensation earned for providing the forex trading service. In addition, brokers also pay their introducing agents and affiliates from the spreads of the traders that these agents have recruited into their platform.

Monetary Value of the Spread

The lot size and the number of pips that make up the spread will determine the monetary value of the spread.

Recall that a standard lot is worth $10 per pip ($100,000 trade value size X 0.0001). Therefore, it a trader is trading a currency pair with a spread of 4 pips on a standard lot, the monetary value of the spread is $10 X 4 = $40.

Understanding the monetary value of the spreads for a currency pair will help a trader balance out risk by using the appropriate trade sizes, or selecting currency pairs with reduced spreads to save cost.

Issues with the Spread

There are times when spreads may widen unexpectedly, even on platforms that offer fixed spreads. When there is severe market volatility with lots of traders jostling to get into positions, some traders may be filled at prices which make the spread a lot wider and more expensive for the trader. Such an event could occur when there is a high impact news item such as the US Non-farm Payroll report, or when there is a natural disaster or terrorist attack which causes panic in the financial markets. Even when pending orders are used, this problem could stil occur.

The only way to prevent this is to use an ECN platform. Usage of an ECN broker will also attract commissions in addition to the spreads that the trader pays. However, the virtual non-existence of the slippage phenomenon compensates for the increased charges.

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