Whenever you’re looking to trade on the foreign exchange market, you’ll almost always be presented with a set of two prices for any given currency pair.
These are referred to as the ‘bid’ or buying price — the price that the broker would be willing to pay you (using the counter currency) for the base currency — and the ‘ask price’, denoting the price at which the broker is willing to sell you the base currency in exchange for the counter currency.
The difference between these two figures is what’s commonly known as the ‘spread’, and for traders essentially constitutes the cost of making that particular transaction. Since brokers deal with both the buyer and seller during a trade, they make their profit from the spread margins on either side; it can be thought of as their reward for facilitating the trade and shouldering any potential risks that could emerge.
In fact, this process is precisely how so-called ‘no commission’ brokers make their money — they simply build their profit margin into their trade prices, instead of charging clients a separate fee for their services!
Measuring Spreads Like a Pro
Forex spreads are measured using a unit known as a ‘pip’ (short for ‘point in percentage’), which represents the smallest measurable unit of movement in price between a pair of currencies.
For most currency pairs, it’s the equivalent of 1/100th of 1% or ‘one basis point’, i.e. $0.0001. For instance, if we’re looking at the EUR/USD pairing, then 1.1063/1.1065 would indicate a total spread of 2 pips.
However, it’s also worth noting that some pairs — such as those involving Japanese yen — only tend to be quoted to two decimal places due to the way these currencies are configured. In examples like these, a USD/JPY pairing of 110.50/110.53 would simply represent a 3-pip spread.
What are Fixed Spreads?
Fixed spread trading is a type of trading arrangement whereby the spreads offered by brokers to prospective traders stay constant, regardless of the conditions of the wider currency market.
This system is mostly utilised by the larger ‘market maker’ brokers, many of whom operate by buying huge sums of a given currency from a liquidity provider to then sell on, in smaller portions, to traders.
These types of brokers often make use of their own in-house dealing desk, offering clients unique buying and selling prices that are set by the company themselves; this allows them to organise their own spread margins as they see fit.
Traders using fixed spread services benefit from greater predictability with regards to transaction costs than with more free market-based systems, as spread margins change at much slower rates.
On the other hand, many clients suffer from being presented with infamous ‘requotes’ by their brokers once a transaction has been requested, which effectively move the goalposts and alter the spread to a revised (and invariably less enticing) price.
There is also a risk of what’s known as ‘slippage’ due to brokers being unable to consistently maintain a fixed spread for extended periods, meaning the price you ultimately get could be less favourable than the one that you originally wanted.
What are Variable (Floating) Spreads?
By contrast, variable or floating spreads — which, as the name suggests, are always changing depending on the market forces of supply and demand — tend to be offered by brokers who don’t use their own intermediary dealing desk to decide their spread margins.
Instead, these brokers operate by sourcing prices from multiple liquidity providers and passing them on to their customers directly, without exerting any influence over them. This approach means that these brokers ultimately have no control over the spread as rates constantly fluctuate (either widening or tightening) within the marketplace as a whole.
Because variable spread brokers do not set their own rates, you don’t have to deal with any frustrating requotes, and the overall pricing structure tends to be more transparent. Competition from multiple liquidity providers also means that prices are generally more favourable than when working with a single fixed spread broker.
Despite this, there is still a chance of slippage at times when the market is particularly volatile and moving at an accelerated rate.
Which Type of Spread is Preferable?
As with any type of trading system, both fixed and variable spread transactions have their own unique advantages and drawbacks.
Fixed spreads are typically more convenient for traders with smaller accounts — as they’re characterised by having lower capital requirements, so you can trade with less actual money at your disposal — as well as those who trade less frequently.
Traders with larger accounts and those who trade more regularly (and during peak hours, when spreads are often at their tightest), meanwhile, tend to fare better with variable spreads due to the faster execution and lack of hassle brought about by requotes.
Conversely, scalpers — whose strategy relies on lots of quick-fire transactions for modest gains — are less likely to engage in variable spread trading due to the risk of rapidly widening spreads mitigating their hard-earned profits.
Spread Costs and Calculations: What You Need to Know
In order to discern how the spread affects the cost of your transaction in real terms, you need to apply a quick bit of maths.
Put simply, the spread cost is:
spread value (in pips) x the number of lots x the pip cost per mini lot
(A single mini lot corresponds to 10,000 units).
The pip cost is linear, and a greater position size will ultimately lead to a larger transaction costs overall; indeed, margins that appear small at first glance can frequently quickly add up into considerable commissions for brokers. This is particularly true when dealing with large-scale institutional clients who often buy and sell millions of units in a single transaction.
For example, a spread of 0.0002 GBP might seem negligible, but if you’re trading a million units that would translate to a charge of £200! These spread costs are unfortunately a necessary evil for the most part, and the convoluted ways of avoiding them are really only recommended for expert, highly experienced traders.
However, making sure you trade during peak market hours as much as possible will help to minimise the cost of trading, as greater competition amongst brokers incentivises them to tighten their spreads.
You should also avoid trading with less common currencies for this same reason, as the relative scarcity of vendors can lead to brokers raising their spread margins without the risk of losing business.
