Understanding the basics in Forex Market - Spreads

The spread in forex trading refers to the difference between the bid (sell) price and a currency pair's ask (buy) price. 

The spread is a small cost charged by some brokers and is built into the bid and ask prices of currency pairs. Brokers using spread as charges normally do not have separate commission fees, giving them the name - No Commission Brokers. 

How to measure spread in forex trading?

The spread is measured in pips, which is the smallest unit of price movement for a currency pair. 

In general, a pip means the fourth decimal place of the price of a currency pair (except for JPY, where a pip refers to the second decimal place). 

Here’s an example of a 2 pip spread for the EUR/USD currency pair.

How to calculate spread costs?

To calculate how much the spread costs, you just need to multiply the spread value (in pip) and the number of lots you’re trading by the cost per pip.

Spread value x Number of lots x cost per pip = Spread costs

Continuing from the above example, if you are buying a standard lot of EUR/USD currency pair, with a 2 pip spread, with the cost per pip of $10, your spread cost can be calculated as below:

Spread value x Number of lots x cost per pip = Spread costs

2 Pips (spread value) x 1 (standard lot) x $10 (cost per pip) = $20 (spread costs)

If you’re buying 5 standard lots of EUR/USD, with the same spread value, your spread costs will be calculated as below: 

2 Pips x 5 x $10 = $100

If you’re buying 5 standard lots of GBP/USD, with a spread value of 2.2 pips, your spread costs will be calculated as below: 

2.2 Pips x 5 x $10 = $110

Note that the spread costs will increase when your lot size or spread value increases. Similarly, when your lot size or spread value decreases, the costs of the spread will decrease as well.

What affects the spread value?

Spread can be affected by various factors in the market. In general, the major currency pairs will have a tighter spread value compared to emerging market currency pairs. 

Other than the types of currency pairs, liquidity and volatility in a market will affect the spread value as well. A market with lower liquidity and higher volatility will lead to a wider spread value. Vice versa, a market with higher liquidity and lower volatility will lead to a tighter spread. 

When there is an overlap of major forex market sessions, the spread value will be tighter as well. 

Types of spreads

Spread in forex trading refers to the difference between a currency pair's bid and ask price. It is a small cost charged by some brokers and is built into the bid and ask prices of currency pairs.

Forex brokers offered 2 types of spreads: Fixed spreads and Floating spreads.

In this article, we will outline the differences between these two types of spreads.

Fixed spread

A fixed spread is the amount of spread fixed by a broker and will not change regardless of the market conditions. Regardless of whether the market is volatile or not, the amount of spread for the currency pair will remain the same according to the amount that the broker has fixed. 

Pros and Cons of Fixed Spread

The advantage of a fixed spread is that it makes transaction cost more predictable. Traders can easily calculate the cost for each of their transactions. Besides, with a fixed spread, volatility and liquidity in the market will not affect the spread value. As mentioned earlier, high volatility with low liquidity will normally cause spreads to widen. In such a situation, traders trading with a fixed spread pricing may still enjoy the same transaction cost fixed by their brokers (which is normally lower than the floating spread pricing in high volatility situations).

The disadvantage with fixed spread is that requote and slippage may occur. Requote refers to when your broker requests you to accept a new price due to price changes in the market and Slippage refers to when your order was executed at a price different from the intended price. During high volatility and low liquidity situation, requote and slippage may occur more often than usual with fixed spread brokers. Furthermore, fixed spread brokers may charge a commission on top of the spread charge for certain currency pairs. This will increase the cost of trading. 

Floating spread

Contrary, a floating spread (also known as a variable spread) will change according to market conditions. The floating spreads will widen or tighten based on the supply and demand of the overall market. 

Pros and Cons of Floating Spread

With floating spreads, the advantage is that there is no requote issue, and slippage issues are less likely to happen. This is because spreads are already quoted according to the market price movement. Furthermore, in a market that is less volatile and has high liquidity, traders usually get to enjoy a tighter spread with floating spread pricing compared to fixed spread pricing. Brokers who charge floating spreads generally do not charge commission as well.

The disadvantage of floating spreads is that the transaction costs vary for every trade. It makes calculating the transaction costs more difficult. At times of high volatility and low liquidity, the floating spreads will widen to reflect the changes in the market, which can lead to higher execution costs for traders. Hence, with floating spreads, it is also important to keep an eye on any announcement or event that may cause higher market volatility.

Fixed Spread vs Floating Spread in table

For a summary of how fixed spread and floating spread differ, you can refer to the table of comparison below:

How to choose? 

Fixed spread and floating spread have their advantages and disadvantages. Choosing one over another will depend on a trader’s trading strategy. 

In general, traders with smaller capital, who trade less often and are less sensitive to the intraday market movement will benefit from fixed spread pricing. Traders with larger capital often trade during peak market hours (when spreads are tightest) and are more sensitive to the intraday market movement will find floating spreads better for them. 

Traders who want to avoid requotes and fast trade execution will also prefer floating spreads.

VCPlus like many other forex brokers uses floating spreads to allow traders to execute trades quickly. The spread range with VCPlus for major currency pairs is as low as 1.5 pips. They also have a cap of a maximum of 8 pip spread. Get started now by opening an account.

Conclusion

Spreads in forex trading refer to the difference between a currency pair's bid and ask (buy) price. It is a small cost charged by some brokers. There are 2 types of spread offered by brokers in the forex market: fixed spread and floating spread. When opening a trading account with a broker, traders must be clear on which type of spreads the broker offers and choose according to their trading strategies.