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Have you ever wondered how a forex broker makes money? Normally, a brokerage company would charge their clients a type of fee called “spread” which is regarded as their main source of income. This is a simple yet essential term in forex trading. Keep reading this article, you will learn the very fundamentals of a forex spread and find out whether or not it affects your trades.
What is a Forex Spread?
A forex spread, or fully known as a bid-ask spread, is the difference between the bid price a buyer is willing to pay for a currency pair and the asking price a seller is willing to accept. Both the bid and ask price would be displayed on a trading platform as followed. Accordingly, the ask is 1.18029 whilst the bid is 1.17999. Understanding these prices would support forex traders to calculate forex spreads they have to pay.
The definition of a spread also applies to other financial markets, not just in the forex market. However, as currency pairs are the most liquid asset among all financial instruments, the forex market has one of the smallest spreads which can even be measured in fractions of dollars.
There are two types of spreads, including fixed and variable ones. As the name states, a fixed spread does not change in value regardless of market conditions, even when the market is volatile. Therefore, a fixed spread can be wider than a variable one to compensate for potential losses of a broker that are induced by unfavorable price fluctuations.
When a bid-ask spread is floating or variable, that means it can expand or tighten depending on the market volatility or supply and demand of currencies you plan to trade. Although a variable spread gives traders a feeling of uncertainty about trades, especially when it would increase rapidly during the high volatility, it is normally much tighter than a fixed one.
Theoretically, a fixed spread is believed to suit novice investors because they need not worry about whether unexpected market movements may affect charges paid to their forex broker. Meanwhile, a floating spread suits professionals. However, most forex traders now offer variable spreads. They advise new clients to trade major currency pairs first as those majors are less volatile and have large trading volumes, which leads to tighter spreads they offer.
Forex Spread Calculation
In the forex market, a spread is measured in pips. Shorting for Percentage in Point, a pip is a standardized unit of change in an exchange rate of a currency pair. Normally, for most major currency pairs, a pip is one unit of the fourth decimal place (equivalent to 0.0001). However, for those having the Japanese Yen on one side, a pip is one unit of the second decimal place (or 0.01). Accordingly, a forex spread would be calculated by subtracting the bid price from the asking price of a currency pair.
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Look at the picture below:
The EUR/USD is priced at 1.18581 as the bid and 1.18600 as the ask. Of which, the last decimal place is a point and a forex spread would be 0.00019 (= 1.18600 – 1.18581) which equals 1.9 pips. This means once a forex trader opens a position, albeit long or short, a forex broker would receive 1.9 pips of spread.
However, this is not a total spread cost the speculator has to pay as the amount still depends on the total number of lots traded. By multiplying the pip value with the trading volume, the trader would calculate how much he or she has to pay the broker. For example, when you trade a standard lot, equivalent to 100,000 units of currency, and your trading account is denominated in the US dollar, your spread cost would be $19 (= 0.00019 x 100,000). In case you only trade with a mini lot (equivalent to 10,000 units of currency or 0.1 lot), your spread cost equals $1.9.
Therefore, the smaller the trading volume you have, the smaller spread is charged. Having said that, whether a forex spread cost is high or low depends on other factors such as currency pairs, trading sessions, and so forth.
What Does a Forex Spread Tell Traders?
A spread plays an important role in forex trading. As already mentioned, most forex brokers primarily make money through spreads. As soon as you enter the trade at the asking price and close it at the bid price, the spread amount would be immediately collected by a brokerage company. It can be said as a basic compensation for forex brokers and any third parties such as introducing brokers (IB).
As most forex brokers now act as dealers – commonly known as market makers, they try to offer a competitive spread for different currency pairs to compete against other major market makers, typically large international banks. However, some brokers that use ECN (Electronic Communication Network) and STP (Straight Through Processing) to directly connect clients with liquidity providers can provide a raw spread account with a very tight spread, even from 0 pip.
Besides, a forex spread can reveal how liquid and volatile a currency pair is. Particularly, a higher than normal spread of some currency pairs indicates that the market is highly volatile and lowly liquid, which means it is difficult to trade those currency pairs in a large trading volume without a considerable change in their exchange rates.
Meanwhile, a low spread is correlated to low volatility and high liquidity, which can imply that currency pairs are easily transacted in a high volume without making the market move too much. Accordingly, the market is working well and perhaps countries whose currencies have a low spread are economically or politically stable.
Factors Behind a Forex Spread
The size of a forex spread is regulated by market makers. Depending on various factors, a variable spread may be widened and tightened by a brokerage company to both ensure their income and attract customers with a competitive bid-ask spread. Accordingly, a forex spread is affected by such following features as:
Market liquidity and volatility
As mentioned in the previous part, a spread size can indicate whether or not a currency pair is highly liquid. In turn, market liquidity and volatility can strengthen or weaken a currency pair. Therefore, the in-depth understanding of these two terms would help speculators, especially beginners, anticipate imminent changes in spreads.
Liquidity is the ability of a currency bought or sold on demand without moving its value too much in either direction. Meanwhile, volatility measures how dramatically the market changes. When the market has high liquidity or low volatility, it means there are a large number of transactions in a certain currency pair. This probably shortens the distance between the highest price purchasers are delighted to pay and the lowest price sellers are willing to accept. Consequently, a forex spread would be tighter.
Under normal market conditions, a forex spread of major currency pairs is lower than that of crosses and much lower than exotics’. Inevitably, majors are formed by top eight currencies (e.g. the US dollar, euro, British pound or Japanese yen) whose countries have strong economies and better political stability, hence they are more heavily traded than others. This results in higher liquidity and then lower spreads.
Having said that, their spreads may become bigger before any major news is announced such as US Election results or Brexit. In this case, there may be big changes in the supply and demand of currencies that a trader wants to bet on. This increases the market volatility and directly renders currency pairs less liquid, thus widening spreads. In other words, expanding spreads of major currencies show concerns of speculators about the financial health or political situations of countries holding them.
Therefore, watching an economic calendar regularly to keep up with upcoming major news would help investors to make more precise predictions about whether the spreads of currency pairs will be widened.
Normally, currency pairs are continuously bought and sold in four trading sessions that include London, New York, Sydney and Tokyo sessions and last from 10 PM GMT+0 on Friday to 10 PM GMT+0 on Sunday. Also, the more trading volume an investor has, the smaller spread is incurred.
The picture above indicates when four trading sessions work and when investors trade the most. More particularly, when two trading sessions cross, especially once there is an overlap between two biggest market economies (London and New York), a number of orders to buy and sell currency pairs, typically EUR/USD, would rapidly increase, leading to the high liquidity of currency pairs and hence narrowing spreads down.
On the contrary, if a trader speculates on a currency pair out of its normal trading session, for example, trading the euro throughout the Asia session instead of the European session, not so many traders get involved in the currency, consequently causing the lack of liquidity. This forces a forex broker to increase spreads to compensate for the potential risk of a loss when their customers cannot close their positions.
That is why beginners are advised to trade at the right time or during major forex sessions when spreads are low to avoid monetary risks.
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