Importance of Forex Spreads

forex_spreads

The spread is a key part of any financial market. If you have done Forex trading before, then you have probably noticed that there are two types of prices – an ask price that is used when you buy the asset, and a bid price that is used when you sell the asset. Usually, there is a small difference between these prices – this difference is called the spread.

Best Forex Brokers for United States

This spread is usually very small and in short, it shows the commission that the broker receives for every opened trade. If you are new to the Forex market, then you probably underestimate the importance of the spread’s value, but let us tell you this is one of the most important things you should check when choosing your Forex broker.

Most trading systems and strategies are highly dependent on the spread offered by the broker. Often a spread value that is too high may render a trading system useless. If the trading system requires you to open many positions in a short amount of time, then it is very important that you find a Forex broker that offers low spreads. This is why high frequency traders always pay close attention to the spread that each broker offers.

The Forex Spread Explained

Now, let’s delve deeper into the subject of trading spreads and how they work. All markets have spreads and Forex is not an exception. Simply put, the spread represents the difference between the price at which an asset (a currency pair in this case) is bought and sold.

Currencies are always quoted with two prices, a bid and an ask price. The price at which a trader buys the base currency of the pair is the bid price. The ask price denotes the price said base currency is sold at. For clarification, the base currency sits on the pair’s left side while the counter currency is located to the right.

This pairing serves to indicate how many units of the counter currency you can purchase with a single unit of the base one. The buy prices will always be lower than the sell prices. The actual underlying value of the currency pair is somewhere in between. Trading the majority of Forex pairs is commission-free. Brokerages apply the spreads to cover the costs associated with the execution of the trades. This also helps them reduce their risk exposure.

The size of the spread depends on a variety of factors including what currency pairs one is trading and how volatile the respective market is. The size of the positions you open and the brokerage you trade with also matter. Some online brokers tend to offer more competitive spreads than others.

How Spreads for the Forex Markets Are Quoted

The spread is measured in pips, which is an abbreviation from “percentage in point”. A pip represents the smallest possible movement in the prices of the currency pairs. Normally it is placed at the very end of the price quote in the last decimal position.
The majority of currency pairs are quoted with four decimal positions. One exception is made for pairs that involve the JPY currency, in which case there are usually only two digits after the decimal point. For instance, a single pip would be expressed like 0.0001 for a major pair like the EUR/GBP and as 0.01 for the GBP/JPY.

Calculating the Forex Spreads

Let use an example to see how traders can calculate the cost of a given position. Let’s assume you are interested in opening an order for the EUR/USD and your broker of choice quotes it at 1.18118/1.18127.
Since the spread reflects the difference between the bid and ask prices of the pair, it would be equal to 1.18127 – 1.18118 = 0.00009 in this case. This means here we have a discrepancy of 0.00009, which corresponds to 0.9 pips. The trader pays this built-in cost as soon as they open a position for the EUR/USD.

All major online brokers include price charts on their websites so that traders can compare the average spreads for the different currency pairs. Now that we have established that the spread for EUR/USD is equal to 0.9 pips, we can determine how much opening one such position would actually cost us.

Since currencies are traded in lots, we can calculate the actual cost in money if we multiply the spread by the pip cost for a lot equal to 10k. Let’s do that for the EUR/USD pair from our example. The overall cost of opening a position for a 10k lot would be equal to 0.00009 x 10,000 = $0.9.

The cost obviously fluctuates depending on the size of the lot. It would be higher for one standard lot, which consists of 100k units of the respective currency. Thus, the trader’s expenses will grow to 0.00009 x 100,000 = $9 when they purchase a standard lot of the EUR/USD with a spread of 0.9 pips.

Note that if your trading account has been registered in another currency, you must convert it to the USD. Another thing that bears consideration is that some brokerages tend to reduce the spread during certain trading hours. The purpose of this is to motivate customers to invest more during the periods of higher demand and create more liquidity.

Fixed and Floating Forex Spreads

Online brokerages normally offer two types of spreads – a floating (variable) one and a fixed one. Fixed spreads don’t change over time while the floating spread is very dynamic. It is up to you to decide if your strategy will be more successful with a fixed or a floating spread.

Each of the two types has its advantages and disadvantages. One benefit of the fixed spreads is that they enable the trader to determine the cost of their positions beforehand. They remain stable regardless of what the volatility or interbank liquidity of the underlying asset is.

This enables investors to draw up an adequate short-term or long-term strategy. Fixed spreads ensure higher levels of transparency when it comes to pricing. They are considered more suitable for volatile market conditions. One major disadvantage of fixed spreads is that they are usually higher than variable ones.

By contrast, floating spreads are constantly changing but tend to be tighter than fixed spreads. The fluctuations in ask and bid prices result from increased market liquidity and volatility, trading activity, supply and demand.

These spreads may float several dozens of pips upward during news time. Because of this, floating spreads are considered more suitable for those who trade long-term positions that are not influenced by news events. The main con of variable spreads is that they can expand dramatically during certain periods and cost the trader more than fixed spreads.

Inverted Spread

By now it has become apparent traders enter their positions at a nominal loss due to the built-in spreads. This is always the case unless an investor is trading with an ECN brokerage that gives them direct access to the currency markets. Such brokers implement electronic communication networks or ECNs and normally ensure very fast speeds of order execution.

With ECN brokers, it is sometimes possible for the spreads to upend or altogether cease to exist for a couple of seconds. This phenomenon is known as an “inverted spread”.

However, the abnormality is rarely observed and most experienced traders consider it undesirable because it might designate the investors’ confidence in the short-term markets has dramatically plunged.

Spread Indicators

Seasoned investors consider it handy to have the spread size at a glance. This is achievable with the help of the so-called spread indicators available for download in trading platforms like MetaTrader 4. Novice investors often skip this step which ultimately results in higher trading costs for them.

Spread indicators are used to measure the discrepancies between the bid and ask pricing of instruments like currency pairs and securities. They normally come in the form of curves in charts that indicate in which direction the spreads are moving. This helps with visualisation since you always have the spreads at a glance.

You can gain access to spread indicators by downloading the MetaTrader Supreme Edition plug-in at no cost. This feature can be particularly useful for short-term traders who open positions frequently. Scalpers also take advantage of spread indicators to trade in a more cost-effective manner.

Price Movements and Margin Calls

One thing to keep in mind, especially when you are trading with leverage, is that your broker might send you a margin call when the spread extends dramatically. The margin is among the most crucial concepts a trader must grasp as it denotes the amount of money they must bring out to open a trading position.

Whenever a position goes into a negative territory, this causes their account’s margin level to dramatically plummet. The amount of money in the live account’s balance is no longer sufficient (i.e. less than 100%) to cover the cost of the position and the margin requirements of the brokerage.

The broker would inform the trader, either via email or by a push notification, that they need to refund their account to maintain the position(s) open. This is known as a margin call. If the trader fails to do this, their positions will be immediately liquidated.

Receiving margin calls is highly undesirable and can result in dire consequences for the investor. They have the potential to transform a bad investment decision into a much bigger issue such as incurring debts. There are various ways to prevent margin calls, including keeping track of your margin regularly, setting stop losses, and maintaining an adequate balance in your account.

How Important Are Spreads from the Perspective of Brokers

If you think foreign exchange brokerages generate profits solely by charging commissions and building spreads into the positions’ prices, you are terribly wrong. Many market makers actually take the opposite side of their customers’ trades. Most retail customers tend to lose money which ends up straight into the pockets of the brokerages.

Imagine a brokerage company whose sole occupation is to issue position prices after you sign up and top up your live balance. If most of the customers of one such broker make poor trading decisions and lose money without ever cashing out from their accounts, the broker will generate significantly more gains by keeping the deposited money than they would from fees and spreads.

Of course, larger spreads and higher commissions translate into more profits for the brokerages. However, spreads are generally far more important to traders than they are to brokers. They are basically the price you must pay to do business with a given broker. The more often you open positions, the greater the importance of the spread and its impact on your long-term profitability.

Factors that Influence the Forex Spreads

It makes sense that with variable spreads the difference between the ask and bid pricing will fluctuate from one moment to the next. What is more difficult to grasp is why these shifts in the spread occur in the first place.

The width of the spread is influenced by a variety of factors including the trading volume, the volatility of the different currencies, and the economic and geopolitical climate. Let’s have a closer look at them.

Trading Volume

By and large, the width between the bid and ask prices is affected by the trading volume of the different currency pairs. Greater trading volumes indicate that there is higher liquidity in the market, which, in turn, results in lower bid and ask spreads.

There is a lot of buying and selling of currencies going on simultaneously and this leads to a concurrent upsurge in bids and a downturn in offers. This tightens the observed bid/ask spread.

These circumstances explain why the spreads hold out at such tight rates in the large-volume currency market in comparison to other financial markets. And this is despite the fact that foreign exchange brokers normally do not charge other fees and commissions as compensation for the risk they face as market makers.

Periods of Economic or Political Uncertainty

The current geopolitical and economic landscape also has the ability to impact the bid and ask prices. Whenever a nation goes through a period of high inflation and other forms of economic uncertainty or finds itself amidst a clamorous political climate, its currency would normally be associated with greater risk.

Such countries typically lack an adequate approach toward their monetary policies and suffer from relatively high rates of inflation. In turn, this causes the spread to widen since brokers would associate investing in such nations’ currencies with higher risk. They will only sell it at a premium.

Those who seek to buy the currency would only do so at a discount to offset the high risk of the purchase. As a result, this causes a wider gap between the bid and ask prices and leads to a drop in the trading volumes since there are fewer investors trading the markets.

Large Banks and Dealers

Apart from investors who purchase and sell currencies to capitalize on the swings in their prices, some financial institutions, mostly large banks, typically also take the role of dealers in the foreign exchange markets. Such dealers generate profits mostly from the spread without holding on to a given currency for long periods of time.

The greater the number of such dealers on the market, the lower the spreads tend to get. When the competition for the investors’ funds is more severe, the brokers would naturally compress the margins and lower the spreads.

The Liquidity and Volatility of the Currencies

Unstable central banks and inadequate monetary policies also bring about changes in the value of the currencies. When traders get scared off by uncertainty and withdraw from the markets, the brokers will naturally drive the spreads upwards as a means to compensate for the drop in liquidity.

Volatility also influences the gap between bid and ask prices. The brokers tend to widen the spreads further whenever the market becomes more volatile because this increased volatility causes the risk they take on to also rise.

The spread is particularly susceptible to growing when the market makers anticipate unforeseen and acute price movements. This is why wild market fluctuations can usually be observed around the time of important economic data and news releases.

How to Reduce the Forex Spreads

You can never become a successful investor if you do not learn how to trade in a cost-effective manner. Experienced traders inevitably look for value before they open any given position. They always pay attention to how much a trade will cost them and only do business with the brokerages that offer the sharpest spreads.

Choose Brokers with Floating Spreads

As we previously stated, there is a tendency for variable spreads to be considerably tighter than fixed ones. It is typical for market makers to loudly advertise their fixed spreads but in most cases, this is nothing but a marketing ploy that aims to attract new traders and make them sign up.

Such liquidity providers open positions against their customers rather than transferring their orders to the open market. The trouble with this practice is that it creates a conflict of interest. After all, the market maker will never sacrifice their own profits for the sake of yours.

Also, it is common for such brokers to refuse to execute the trades of some customers under certain market conditions. Fixed spreads normally target novice traders who lack experience and don’t know any better.

Trade High-Liquidity Pairs

If you seek cost-effectiveness, it would be a good idea to predominantly trade high-liquidity currency pairs. Of course, exotic pairs may seem more appealing due to the big fluctuations in the prices that often occur with them. However, trading them is significantly more volatile and is unsuitable for those who are new to the markets.

Novices should start with majors like the EUR/USD, GBP/USD, EUR/GBP, USD/CHF, AUD/USD, EUR/JPY, and AUD/JPY. Such pairs have the highest liquidity and typically come with the most cost-effective spreads.

The rule of thumb is that the greater the trading volume of a given currency pair is, the narrower the spread the brokerages tend to offer for it when the market conditions are normal. By contrast, more exotic currency pairs like USD/ZAR, for example, have considerably broader spreads that sometimes can reach 90 pips or more.

Refrain from Trading Before and After Major News Releases

It is crucial to remember that the spreads can sometimes run off the rails and suffer extremely wild fluctuations even when one is trading major pairs with a good brokerage. Such tendencies typically begin to manifest themselves right before or after important news releases.

At times, the impact of the news on price movements is so enormous that Forex brokerages boost the spreads’ width dramatically before and after the announcements in order to reduce their risk exposure.

Because of this, traders must keep a close watch on their calendars each day so that they can detect the times when news may influence the markets adversely. Needless to say, they should refrain from entering positions immediately before or after such releases.

Pick the Right Trading Hours

Novices should choose the right trading hours because the time of day may also influence the spreads. The trading costs are at their lowest during the four main trading sessions (New York, Tokyo, London, and Sydney) because of the high volumes of currency pairs that are being traded.

Seasoned investors prefer to trade during these hours so they can benefit from the tightest spreads. The latter become even lower when the New York trading session overlaps with the London one, which occurs between 8:00 AM and 11 PM EST.

Also, the prices of some currencies like the EUR are prone to move less during certain periods of the day. Smart traders use this to their benefit and open positions only during periods of reduced volatility.

Beyond Spreads

Cost-effective trading is not achieved solely by looking for the lowest spreads. What also matters is how solid and quick the order execution of the brokerage is. The orders of traders must be executed at the same prices they see at the time of clicking the buy or sell button.

If execution is slow, the prices might move several pips away in the wrong direction so that the order is placed at a wider spread, which ultimately costs traders money. And the opposite – when execution is quick, this ensures the traders’ orders are filled at the price rates the broker advertises.

This prevents negatives such as slippage and requoting. Delays are likely to have bad consequences since the foreign exchange markets are very dynamic and the prices can move by the millisecond.

Spreads and Currency Pairs

The spread is different for each currency pair. For example, volatile currency pairs usually enjoy a smaller spread, while low liquid pairs usually include a higher spread. This simple fact is one of the main reasons why so many traders prefer to use the EUR/USD currency pair since its spread is relatively low. This currency pair is especially popular among scalpers who need the lowest spreads possible.

An example of a currency pair that has a very high spread is CAD/NZD. Although its spread is quite high, there are still some currency pairs that include an even higher spread. Most traders avoid trading such currency pairs, unless they have a special strategy that requires high spreads to work.

Trading the EUR/USD pair is one of the easiest ways to start your Forex trading career. Keep in mind that if you decide to switch to another pair, you’ll need to find a reliable and safe long-term strategy, because the higher spreads will have a high impact on your losses and profit.

Conclusion

Understanding the spread is of crucial importance for any successful trader. If you trade with brokers that charge high spreads, you will be inevitably hit by the extra costs, especially if you are a day trader who opens and closes positions very frequently.

We would recommend you to look for Straight Through Processing (STP) or Electronic Communication Network (ECN) brokerages rather than using the services of dealing-desk brokers that reprocess trades and charge wider spreads. Above all, you must pick a broker of fine reputation that is adequately and strictly regulated to ensure a higher level of safety for you and your funds.

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