What is the spread in forex?
Forex brokers always quote two different prices for currency pairs: the bid (buy) and ask (sell) price. The difference between these two prices is known as the spread.
Generally speaking, the spread is how “no commission” brokers make their money. Instead of charging separate fees for making trades, the cost is built into the buy and sell price of the forex pair you want to trade.
The spread is usually measured in pips, which is the smallest unit of price movement of a traded asset. For most currency pairs, one pip is equal to 0.0001. An example of a 4 pip spread for EUR/GPB would be 1.2339/1.2335.
However, currency pairs involving the Japanese yen are quoted to only 2 decimal places – an example of a GBP/JPY quotes would be 131.60/131.52. The example quote indicates a 8 pip spread.
On a typical forex platform, you can see the listing of the bid and ask prices for every currency pair. The snapshot below shows a typical example you will see when making a trade.
The type of spreads seen on a forex platform is determined by the structure of business offered by the forex broker. Spreads are of two types:
Fixed spreads is usually offered by brokers that operate a market maker model of business while variable spreads are offered by brokers operating a non-dealing desk model of brokerage business.
Fixed spreads are spreads that stay the same irrespective of what market conditions are at play at any given time. In other words, conditions of slippage or intense volatility do not affect a fixed spread. Fixed spreads are seen with brokers that offer the market maker business model.
With this model, the broker buys off large positions from the liquidity providers and offers these positions in smaller chunks to traders using a dealing desk. Thus, the market maker acts as the counter party to the trade. In this manner, the broker is able to offer fixed spreads to its clients because they are able to control what is offered to these traders using the dealing desk.
Pros and cons of fixed spreads
Benefits of a fixed spread broker
- Fixed spreads has smaller capital requirements. Trading with variable spreads requires a lot of liquidity which many retail traders cannot afford, so fixed spreads offer a viable and cheaper alternative.
- Trading with fixed spreads also enables better trade planning. This is because traders are always sure of what they can expect to pay when they execute a trade.
- If you are a scalper, then the fixed spread is for you. Scalping involves taking very small profits in many trades within a day. Obviously, the spread will impact on any profits made, so scalpers will be better served using fixed spreads.
Disadvantages of a fixed spread broker
- Requotes are very common with fixed spread arrangements, since pricing is coming from just one source. There will always be times when pricing moves very fast as a result of supply-demand dynamics. With no room for spread adjustment to accommodate these movements, the broker has no option but to ask the trader to accept a new entry price provided for the trade.
- Slippage is another huge problem. When prices are moving fast, the ability of the broker to offer a fixed spread is compromised and the price fill may end up being far worse that if a widened variable spread was use.
- Because fixed spreads are only possible because the broker’s dealing desk is controlling the order flows and execution prices, you may find the concept of trading with fixed spreads not very attractive.
Fixed vs Variable Spreads: Which is Better?
The question of which is a better option between fixed and variable spreads depends on the situation of each individual trader.
There are traders who will find the use of fixed spreads more advantageous than using variable spread brokers. However, the reverse can also be the true for other traders. Generally speaking, traders with smaller accounts and fewer monthly trades will benefit from fixed spread pricing.
Popular choices made by different trader types:
Fixed spread traders
Scalpers: Those who get in and out of the market very quickly, multiple times a day and just take a few pips at a time generally prefer trading with fixed spread brokers. However there is a caveat that a broker offering wide fixed spreads may not be the best fit.
News traders: Traders who trade the news could benefit from using fixed spreads. Some traders have complained of spreads widening to as high as 50 pips during news trades with floating spread brokers, therefore choosing a broker with the fixed spreads brokers could prevent this.
Traders with micro accounts: Low frequency traders and those with smaller deposits using micro accounts could be better off fixed with spread brokers. You will not pay extra commissions (just the spread as discussed above) on trades, unlike with floating spread brokers who charge commissions on each side (buy and sell) of trades.