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What's the difference between fixed and variable spreads?

trading spreadsA spread, in the financial markets is the difference between the bid and the ask price. No matter what markets you trade, you will always see that there is a spread on the price.

If you come across a broker that promises you zero spread, chances are that either they are lying or there are fees that you just don't know about.

Before we begin to explore the difference between a fixed and variable spread, we should understand the concept of spread.


What is a spread?

As previously mentioned, a spread is the difference between the bid and the ask price. The bid and ask are essential terms in trading. They are also called bid and offer price.

The ask price is the price at which the seller is willing to sell the asset. For example, if you were selling a car, you would quote an ask price. This is the price you are asking.

The buyer on the other hand has to match your ask price to buy the car. They do so by bidding.

The bid price is of course the price at which the buyer is willing to buy your car. Some bids might be lower than your asking price. Likewise, some bids might be higher than your asking price.

When the right bid is made from the buyer to match your asking price, a deal or a transaction is done.

You can see that the terms are interchangeable.

If you want to buy a stock or a currency pair, you will get the ask price. If you want to sell a stock or a currency pair, you will get the bid price.

now you might wonder what a spread has to do with all of this?


Example of bid and ask price

Imagine you are a used car dealer.

A client comes to you and wants to sell their car. You quote them a bid price. This is the price you want to buy the car for. After the car is sold at the bid price, you now list the car in the market.

Another client comes to you wanting to buy the car. This time, you quote the ask price. The price you are asking to sell the car.

If the above is clear so far, you will know that in order to make a profit, your ask price must be higher than your bid price.

The difference that you make in this transaction is the spread, the profit you make from the deal.

So, let’s put some numbers to the above.

Client A, Jack wants to sell his car. Your bid price is $5,000.

Client A sells the car to you. He takes your bid price.

You put this car in the market and quote an asking price of $5,500

Client B, Jane wants to buy the car. She takes your ask price.

Putting it into perspective, you bought the car at $5,000 and sold it at $5,500.

$5,000 was your bid price and $5,500 was your ask price. The difference between these two is $500 which is the spread. This is the spread you make as a dealer.

 

Ask Bid Spread

Bid and Ask prices explained

 

The above picture illustrates the spread and the bid and ask prices at work in a forex context.


How does fixed and variable spread work?

Now that you know what a spread is, let’s explain how a fixed and a variable spread works.

A fixed spread, as the name signifies offers you a fixed spread at all times. The financial markets have their periods of high and low liquidity. When there are lower participants, the liquidity falls. Likewise, when there are higher participants, the liquidity rises.

When there is low interest or participation, the spreads can widen because it is more difficult to liquidate your holding of an asset such as a currency pair.

When there is high interest or participation, the spreads can narrow because it is easier to liquidate your holding of an asset.

You can see that there are both pros and cons for each type of spread.

A fixed spread is good if you want a constant spread all the time. So, whether you trade during low liquidity periods, you can be sure that there is a market to sell to.

A variable spread is good if you trade mostly during peak market hours when liquidity is the highest.

But variable spreads come with a downside. When there is a market shock and there is panic, liquidity can quickly disappear. This could mean that you will not get the best price to buy or sell at. The spreads can widen so much that you could actually end up taking a loss even if your trade was profitable.


What type of spread is best for me?

The answer to that depends entirely on you. A fixed spread is usually offered by a market maker dealer. There are negative connotations with a market maker. But that is a myth. A market maker is there to make a market for you at any time.

This means that it is easier to trade with fixed spreads without having to take the liquidity risk. But at the same time, the market maker also wants to make a profit. So there is a chance that you will see the spread to be a big higher than average.

A variable spread is ideal for markets that are very liquid. In forex, the EURUSD is the most liquid currency pair there is. Therefore, you might be better off trading with variable spreads in this case.

At the end of the day, it is up to the trader to decide what type of spread they should choose. You need to consider the costs of trading, fees, if there are any in order to determine the cheapest way to trade.

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