What are Forex Spreads?

Understanding Forex Spreads.

Forex is priced in pares between the currencies of two different countries. When you make a deal in Forex, you buy one currency and sell another at the same time. You must buy/sell the opposite position if you want to exit the trade. For instance, if you think the price of the Euro is going to rise against the US Dollar. For entering a trade, you need to buy Euros and sell the US Dollars. If you wish to exit a trade, you will have to sell Euros and buy back US Dollars. Your hope is that your expectation was right and that the exchange rate for EUR/USD has actually risen, meaning that you will get more Euros back than when you bought them, and this way you will make a profit.

The claim of every Forex broker is that he is having the tightest spreads in the industry. For a beginner, the topic of spreads in the Foreign Exchange market is very confusing and often very difficult to understand. However, it is to be noted that nothing affects your trading profitability more.

 The first thing you need to know is what the spread actually means. A spread is the difference between the price you buy at and the price you sell at that is quoted in the pips. If the quote between EUR/USD at a given time is 1.2222/24 then the spread equals 2 pips.

How do Forex Brokers make a profit?

The spread is what helps brokers to earn money. Wider spreads will cause a higher asking price and a lower bid price. The result is that you have to pay more when you buy and get less when you sell, making it hard to earn a profit. Very often, brokers don't earn the full spread, particularly when they hedge client positions. The spread helps to compensate for the market maker for accepting risk from the stage it begins a client trade to when the broker‘s net exposure is hedged. 

How important are the Spreads?

The importance of spreads is that they affect the return on your trading strategy considerably. Being a trader, your chief aim is to buy low and sell high as in the case of futures and commodities trading. Broader spreads mean buying higher and having to sell lower. A half-pip lower spread need not necessarily sound like a good deal, but it can be the difference between a fruitful trading scheme and one that isn't so. 

If the spread is tight, better things will happen for you. However tight spreads are significant only when they are paired up with good execution. Quality of execution will determine whether or not you actually get tight spreads. A good illustration of this is when your screen displays a tight spread, but your trade is filled with a few pips to your disadvantage or is cryptically rejected. 

When this happens, again and again, see whether your broker is showing tight spreads but is delivering wider spreads. Some brokers use strategies like delayed execution, rejected trades, stop-hunting and slipping to do away with the promise of tight spreads.

Spreads should always be reckoned in conjunction with the depth of the book. Strangely enough, in the matter of economies of scale, Forex doesn't even behave like most other markets. For example, on the inner-bank market, the larger the ticket size, the larger the spread is. When you see a 1-pip spread on an ECN platform, you have to inquire if that spread is valid for a $2M, $5M or $10M trade, which it believably isn‘t. Many times, the tight spread that is offered is applicable only to capped trade sizes that are very insufficient for most of the general trading strategies. 

Spread policies are different among different brokers and the policies are often hard to see through. This, of course, makes comparing brokers a lot difficult. Many brokers offer fixed spreads that are guaranteed to remain static irrespective of market liquidity. But as fixed spreads are habitually higher than average variable spreads, you are paying an insurance premium during most of the trading days so as to get protected from short-term volatility.

Some other brokers offer you variable spreads relying on market liquidity. Spreads are tighter while there is good market liquidity but they will broaden as liquidity dries up. Choosing between fixed and variable rates depends on your own trading pattern. If you trade chiefly on news announcements, you may be fortunate with fixed spreads, but only if the quality of execution is good.

There are brokers who have different spreads for different clients on the basis of their accounts. Clients making larger trades or those who have larger accounts receive higher spreads, while clients referred by an introducing broker get wider spreads for covering the cost of the referral. Some brokers offer the same spread to all traders.

It can be hard to learn about a company's spread policy because this information and information on trade execution and order-book depth are difficult to obtain. For this reason, many traders get caught up in the offers they receive and take the words of brokers at face value. This can be unsafe. The only alternative is to try out various brokers or talk to those who have.