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Dipping your toe in the water of forex trading has never been easier. Now there are more and more top forex brokers offering great deals, powerful educational infrastructures, and more to attract your business. This is great for you as a potential forex trader, so long as you know some key points about trading forex.
One of these key points that you will encounter right away and that can be the cause of confusion for many, is the spread in forex. In the simplest of terms, this is the difference between the price at which you can buy a currency, and the price at which you can sell it. This price difference allows your broker or other market maker to make a marginal profit on your trading.
Do Forex Brokers Profit from the Spread?
The simple answer here is yes. To understand how this is the case, we have to analyze the forex trading market a little more in-depth:
When placing a trade on any currency you will notice the presence of two prices. These are the bid price and the ask price, or in simple terms, the price you must pay to buy a currency, and the amount you will get for selling that currency. You will notice a slight difference in these prices.
This price difference does in many cases indicate a profit for your broker if they are the market maker, although this may not always be the case when you consider the following.
- The spread is usually very small and this helps to protect the market maker who is facilitating the trade, against any big changes in the market between order and execution of your trade.
- Since almost all the top forex brokers offer some form of commission-free trading and fee-free trading, the spread acts as the only marginal profit area for some.
Common Spread Types
When you are trading forex with any of the top brokers, you are likely to come across two particular types of spread most frequently. These are the fixed spread, and the variable spread. Here is a quick rundown of both, along with a few pros and cons that some traders feel about each.
As suggested by the name, this type of spread is offered by the broker and remains constant for a particular period, usually in the long-term. It certainly will not change during the course of your trading day.
Fixed spreads are typically offered on the most popular, major currency markets such as EUR/USD, USD/JPY, and more that are viewed as very stable markets with only minor fluctuations and a steady, consistent trading volume.
Fixed Spread Pros
- Even in a volatile market, the spread will remain fixed.
- You can accurately predict and prepare for a fixed cost of trading.
- There are typically lower capital requirements when dealing through the fixed spread. This makes it ideal for newer traders.
Fixed Spread Cons
- Even though the spread cost will remain predictable and fixed, you may be exposed to slippage. This is the difference in the price between when you place the order and when it is executed.
- Fixed spreads are typically higher all-round than variable spreads to help provide protection against market changes.
A variable spread again as the name suggests, is the opposite of a fixed spread in the sense that it is changeable and can move fluidly throughout the trading session depending on the volume and volatility of the market.
The majority of top forex brokers will offer variable spreads particularly on riskier or less popular markets that can see a lot of changes in price. This includes minor forex currency pairs, forex trading, and some commodities.
Variable Spread Pros
- With variable spreads, you are less likely to experience slippage on your trades.
- The variable spread can be a good guide toward the current market liquidity and sentiment.
- More often than not, variable spreads are lower than fixed spreads and so can give you a better deal.
Variable Spread Cons
- Slightly more unpredictable if you are trying to plan for precise trading costs.
- Can change a lot within a short space of time depending on the market and your broker.
Understanding How to Manage the Spread
This advice particularly applies if you are utilizing a variable spread from your broker. There are a few ways in which you can try to minimize your own spread during forex trading.
The very first of these is to try and choose a broker who offers you the best value in spreads based on what you know to be your own trading style and needs. If you are not sure about this then a great place to start is a forex demo account. These are offered by the majority of brokers and are fully equipped at simulating a realistic trading environment without the risk.
Since the market, and therefore the spread, can change a lot based on the news, it is a very good idea to have a look at the economic calendar provided by your broker. This will let you know which major economic events are coming up. From there, you can work to decide how you think the spread may be impacted.
Finally, one of the biggest keys when it comes to the spread, is volume. With that in mind then, it is likely you will encounter a lower spread during the major trading session hours around the world. This means New York, London, Sydney, Tokyo. Outside of these times, you may notice an increase in your spread.
How to Choose Forex Spread
This really depends on your trading style, though typically, if you are new to trading, fixed spreads are recommended since these can give you a close to an accurate cost of trading, and capital requirements are usually lower.
For an experienced trader, or certainly, if you are trading on margin, you may want to consider variable spreads for their better value for money especially on higher volumes.
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Anthony is a financial journalist and business advisor with several years’ experience writing for some of the most well-known sites in the Forex world. A keen trader turned industry writer, he is currently based in Shanghai with a finger on the pulse of Asia’s biggest markets.