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AB06 - What is a Spread in Forex Trading?

"It is often said that death and taxes cannot be avoid. But did you know that spreads are another thing that cannot be avoided? This is especially true when you trade the financial markets, or forex in our context. Spread is one of the essential frameworks in the world of trading. Some see it as brokers being greedy, but this is not the case. In this article, we explain in a simplistic way how spreads work and why they are charged by the forex brokers. At the end, it is up to the trader to decide whether a fixed spread broker is better than a variable spread broker. Both these types have their own pros and cons and this is mostly a matter of one’s personal trading style and choice than anything else. Learn about what are spreads in forex and how they influence your trading costs regardless of whether you want to buy or sell."

Have you ever noticed that when you are shopping, you will often find that there is a difference in the price? For example, merchants typically buy lower from their distributors and sell higher to the retail consumers.

The financial markets are no different. This is because, you are after all buying and selling from your supermarket, aka, the forex broker. Therefore, the forex broker tends to buy cheaper and sells higher to you.

This price difference is nothing but the spread. In technical terms, a spread is defined as the difference between the bid and ask prices. The terms bid and ask might seem a bit over the top technically speaking.

These are buying and selling prices. The broker makes a profit by pocketing the difference between these two prices. It is not just forex brokers. For example, if you go to a bank or even to a foreign exchange stall at an airport, you will find that the buying rate is always higher than the selling rate.

These spreads are a way for the merchants (including your forex broker) to profit. You might mistakenly assume that the forex broker is profiting from you. This is in a way correct. But they take the profit or add margins to the buying and selling rates to compensate for the risk that they take.

Spreads are a common feature in the financial markets and there is no way you can avoid them. Whether you trade stocks or futures or spot forex, spread is an essential cost that you cannot avoid.

How do forex spreads work?

Forex spreads work in a rather simple way. You can also identify the spread for yourself. Open up your MT4 trading terminal and head over the price quotation table. Here, you will find some significant difference between the bid and ask prices.

The best way to illustrate this is by the following screen grab from an MT4 trading platform.

On the left side is the price quote table and on the right side is the order window.

AB06 Spread

MT4 Spread Explained

In the above picture you can see an example of the bid and ask prices. Let’s take Silver. You will see that you can sell silver at 15.067, while you can buy silver at 15.091. This falls contrary to the general convention of buy low and sell high.

In the above example, you are actually selling lower and buying higher. This is nothing but the spread. When you first place a trade (let’s say a buy order), your trade has to move the required number of pips in spread in order for you to firstly break even.

In the above example, the spread is calculated as the difference between the bid and the ask price. The spread is 0.024 points. Thus, regardless of whether you buy or sell, the broker makes a profit of 0.024 points. This is the price or the margin you pay to your broker.

Conversely, the forex broker in question is making a profit of 0.024 points whether you want to go long or short on silver.

The convention of spreads

As we mentioned earlier, spreads are found in just about any market and there is no way you can avoid this. However, note that when you trade highly liquid instruments, such as the EUR/USD for example, the spreads are much lower.

But when you move to trading minor currency pairs or even exotic currencies, the spreads tend to widen. A simple way to gauge the liquidity of a market is by the spreads. Spreads are often small when you trade the most popular forex currency pairs.

In one of our previous articles, we covered the different things you should look at when trading forex. Spreads are one of the things to consider. A fixed spread broker usually charges you a fixed spread. They do not change, regardless of the time of the day when you want to transact.

A variable forex broker on the other hand will charge you variable spreads. For example, spreads can be smaller when the market liquidity is the highest (ex: during the U.S. or the European trading sessions) but the spreads on the same instrument can widen during low volume hours (such as the early Asian trading session).

Many forex traders mistakenly believe that a forex broker that only offers variable spreads are better than the fixed spread brokers, also known as market makers. But this is not often the case. With variable spreads, there is a high chance that the spreads can widen during sudden market shocks. This can be avoided when trading with a fixed spread broker because the spreads do not change.

There are both pros and cons with this and something that you as a trader should consider when choosing between a fixed spread or a variable spread broker.

Read 885 times Last modified on Saturday, 25 May 2019 11:32