Question: What you need to know about forex spreads

Question: What you need to know about forex spreads

Answer

In this article, we are going to talk about the spread, which is actually the difference between the buying price and the selling price of a currency pair on fForex.

When trading in the forex market, our broker offers us two prices for the same instrument. One of them, called "bid", is the price at which you can buy the currency pair, and the other x price, called "ask", is the price at which the broker sells when we decide to buy.

Of course, the bid price will be a few points lower than the ask price. The broker always buys at a lower price. Well, the spread is neither more nor less than the existing range between the "bid" price and the "ask" price. We will analyze in more detail this concept that is so important for forex trading.

What is a Forex spread?

When entering a buy order on currency pairs, you need to look at the ask price, at which the broker sells. If, immediately after the purchase, you decide to sell (without even giving the asset time to fluctuate), you will close the operation with a small loss. If you do the same operation, but in the opposite direction (short), the result will be the same.

This loss comes from the difference between the two prices, ie the spread. It actually represents the broker's compensation for executing our buy and sell orders. Even if the position moves in our favor and we make a profit, we will still close that position at that cost, which is deducted from the profit or increases the loss.

All financial intermediaries charge fees for offering the services that allow the trader to trade in the market; the spread is just one way to collect them.

Types of spreads

There are basically two types of spreads in the forex market: fixed spread and variable spread.

The fixed spread: This is a spread that remains unchanged, despite the fluctuations of assets in the market. If, for example, the EUR/USD pair is quoted as follows:

Bid: 1.0964

Ask: 1.0967

We can deduce that the existing spread is 0.0003 points; or what amounts to the same, 3 pips difference. When it comes to a fixed spread, no matter how much the EUR/USD price changes, the difference between the two prices will always be 3 pips.

This type of spread is generally offered by brokers who act as a direct counterparty to the trader's operations (the broker buys when the trader sells and sells when the trader buys, assuming the opposite position with his possible profits or losses). These types of brokers are known as Market Makers. Each currency pair may have a different spread, but it remains constant regardless of price fluctuations.

Variable spread: In this case, the spread does not remain unchanged, it can vary depending on the market conditions at any given time. Following the EUR/USD example above, when it comes to a variable spread, it will not always be 3 pips. Depending on market conditions (liquidity and volatility), the spread may vary.

As a general rule, when the broker offers variable spreads, these are usually lower than in the case of a fixed spread. But the trader knows the risk that the cost will increase at specific times in the market (low liquidity or high volatility).

This type of spread is generally offered by brokers who transfer the trader's orders directly to the market, without acting as their direct counterparty; this type of broker is known as ECN or STP. The spread is established based on the bid and ask prices they get in the market.

How to perceive the spread in Forex

Although it depends on the conditions of each broker, normally the spread is charged together with the opening of a trading position. Whether it is a buy (long trade) or a sell (short trade), as a rule, our trade will start with a small loss. As I said at the beginning of the article, this loss corresponds to the amount of the spread that the broker charged.

At the time of closing the position, a counter-open order will be issued, but the spread has already been cashed in and will only execute the order at the price the broker marks at that time. Thus, the gains or losses from the trade will include the cost of the spread at the time of closing.

Difference Between Commission and Spread

Commissions also involve the fees of the broker to be able to perform their work. The most important difference is how to collect these fees. A commission is charged by the broker each time an order is opened in the market, in other words, it is charged both at the closing and at the opening of a transaction; So we see how the costs associated with trading are doubled. We are talking about the fact that it can be a fixed amount or a percentage applied to the volume of money in the operation.

At the same time, the spread is usually taken only once and is calculated based on the value of each pip (we will soon see how the spread can be calculated in Forex). Next, the spread is always measured in pips, not an amount or a percentage of the amount to be invested.

How to view the spread in MetaTrader 4?

As I said, the spread is nothing but the difference between the offer price (bid) and the ask price (ask) offered by the broker. Therefore, if we look at these two prices, we can calculate the difference and fix the spread points (pips). It is natural that the spread is known when establishing the relationship with our broker since it is one of the commissions that the trader has to face. You must inform us of this parameter, among others, in your conditions of employment.

In any case, the spread can be checked on MetaTrader 4 (and other trading platforms) simply by looking at the prices of each financial instrument. These values ​​appear in the "Market Watch" window, which by default is located on the left side of the platform (can be switched manually). It is convenient to check that the broker complies with the agreed conditions.

How to Calculate Forex Spread

The spread is measured in basis points of the market fluctuation (the minimum movement an asset can make). These points are called "pips" in the Forex market (Point In Percentage). A pip, ie the minimum change in the exchange rate between two currencies, corresponds to the fourth decimal (0.0001). The pairs in which the Japanese yen appears are quoted with two decimal places only, their minimum variation is therefore 0.01 (the second decimal represents one pip).

In summary, to calculate the spread, we basically need to calculate the value of each pip. Then just multiply it by the difference in pips between the bid price and the ask price, i.e. the spread. The monetary value of a pip is expressed in the quoted currency (the second of the pair). Attention, if this currency is not the local currency, it is necessary to keep in mind the exchange rate between the two to make the exact calculation.

A pip can have a value based on the amount we decide to invest. So, if we open a trade of one lot (100,000 units of currency), the value of one pip will be 10 units of the quoted currency (100,000 x 0.0001). If we operate with two lots, 20 units of currency; if we operate with a mini-lot (10,000 currency units), it will have a value of 1 currency unit; etc

If the spread is 3 pips, for example, and the value of each pip is two units of the quoted currency (since we operated with two mini lots), its value will be 6 units of currency. To calculate what it represents in euros, we have to exchange between the two currencies.

Factors Influencing Forex Spread

When the spread has been calculated, one of the most important factors that can influence the establishment of the spread is the trading policy of the broker in question. In other words, we know that there is competition between intermediaries and also other trading factors, each broker will set the spreads they deem appropriate. The trader can therefore accommodate these conditions or seek another broker.

When we talk about variable spreads, the broker will set its prices according to the prices that are in the market (the prices provided by the liquidity providers at all times). Then, the factors that most influence the establishment of the spread in each currency pair will be the following: (whether fixed or variable spreads)

The volatility of the asset: if the volatility is high, the spread increases. This usually happens when economic news publications are produced. The more volatile a financial asset, the higher the spread the broker will charge us.

Market participants: in other words, the liquidity of the asset in question. If we see that there are more sellers and buyers, it will be easy to match the orders and therefore the differential will be smaller; the broker will, in this way, have suppliers in the market at more suitable prices, and this fact is transferred to the trader himself.

How do spreads work?

Once you've seen everything there is to know about spread, let's take a look at it with an example to fully understand how spreads work. For example, suppose we trade long EUR/USD. The prices offered by the broker are as follows: