What Are Spreads in Trading? Which Type of Spread is Better?
If you or someone you know is trading in forex, then learning what are spreads in trading is a must.
Forex brokers quote two prices for currency pairs: the ask and the bid price. The bid price is the price at which you sell the base currency whereas the asking price is the price at which you buy the base currency. The difference between the ask and bid price is known as spread.
Brokers who do not charge any commission make money through spread. Instead of charging a fee for making a trade, the cost is added to the sell and buy price of the currency pair you wish to trade. So, when a broker says they charge no or zero commission, it is misleading because, ultimately, you will still pay commission even though there is no dedicated ‘commission fee’. The amount is just built into the spread.
Measuring Spreads In Forex Trading
Generally, the spread is measured in pips, which are the tiniest units of movement in the price of a currency pair. In the case of most currency pairs, a single pip is equal to 0.0001.
An illustration of one 4 pip spread for EUR/USD would be 1.1051/1.1053. This citation indicates a spread of 2 pips. Here, the bid price is 1.1051, the ask price is 1.1053 and their difference is 0.0002 which is equal to 2 pips.
Currency pairs in Japanese yen are recognised up to only 2 decimal places. So, if USD/JPY is 110.00/110.04, it indicates a spread of 4 pips.
Types of Spreads In Forex
In order to understand what are spreads in trading, you must have knowledge of the types of spreads that exist. The spreads that you will see on a trading platform rely on the forex broker and the way they make money. There are two types of spreads: Fixed and Variable/Floating.
Fixed spreads are generally proposed by brokers that conduct business using a dealing desk model or market maker while floating or variable spreads are offered by those brokers that operate a non-dealing desk model.
Understanding Fixed Spreads In Forex
Fixed spreads do not change regardless of the market conditions prevailing at any given time. More simply, whether the market is quiet or volatile, the spread remains the same.
Brokers that operate a dealing desk model or market maker offer fixed spreads. The broker purchases larger positions from their liquidity provider and provides these positions in small amounts to traders using a dealing desk. This implies that brokers act as counterparty to their client’s trade.
By having a dealing desk, forex brokers are able to offer fixed spreads, as they are able to influence the prices they show to their clients.
Advantages Of Trading With Fixed Spreads
Fixed spreads have lesser capital needs, so trading with fixed spreads provide a cheaper substitute for traders who do not have enormous capital to begin trading with.
Trading with fixed spreads also makes determining transaction costs more predictable. As spreads remain the same, you are always sure of what should you expect to give out when you open a trade.
Disadvantages of Trading With Fixed Spreads
Since pricing comes from only one source (your broker), requotes can take place often while trading with fixed spreads. And, by often, we mean as often as the Kardashians update posts on Instagram.
There will be times when the market is volatile and the values are quickly changing. The broker will not be able to expand the spread to remodel for current market conditions. So, if you enter the trade at a particular price, the broker will block the trade as well as ask you to conform to a new price. Thus, you will be re-quoted at a different price.
A re-quote message will flash on your trading platform letting you know that the price has changed and ask you if you agree to the new price. Typically, the price will be worse than the one you were given previously.
Another issue is slippage. When prices are moving rapidly, the broker is not able to consistently control a fixed spread and the price that you subsequently end up with after going into a trade will be completely different than the desired entry price.
Understanding Variable Spreads In Forex
Just as variables are always changing, variable spreads are also fluid. With variable spreads, the difference between the ask and bid prices of currency pairs are continually shifting. They are offered by non-dealing desk brokers who get their currency pairs pricing from various liquidity providers and circulate these prices to the trader without going through a dealing desk.
This means that there is no control over the spreads and they will narrow and widen based on demand and supply of currencies and market volatility.
Advantages of Trading With Variable Spreads
Variable spreads remove experiencing requotes as the differences in the spread factors are due to market conditions.
Another benefit is that trading with variable spreads provides more transparent pricing, specifically because having access to prices from several liquidity providers generally means competitive prices.
Disadvantages of Trading With Variable Spreads
Variable spreads are not ideal for scalpers. The expanded spreads can rapidly eat into any gains that the scalper makes.
Variable spreads are simply bad news for traders as they may widen so much that what seems to be a highly lucrative deal may turn into a big loss in the blink of an eye.
Which is Better: Fixed Or Variable Spreads?
This very much depends on the requirements of the trader. Generally speaking, traders who have smaller accounts and who do not trade frequently will gain more from fixed spread pricing.
Those who trade frequently when spreads are tightest and have larger accounts will gain from variable spreads. Additionally, traders who want to avoid requotes and experience fast trade execution should choose to trade with variable spreads.