What is spread?
The spread is nothing but the difference between the bid price and the ask price. Whenever you look at any forex chart you see two prices of that particular chart as shown in the image below.
The first price is the bid price and the second is the ask price.
BID PRICE - The bid is the price at which you can sell the base currency.
ASK PRICE - The ask is the price at which you can buy the base currency.
And the spread is nothing but the difference between the bid price and the ask price. To be more precise, when you subtract the bid price from the ask price, you get the spread of the respective currency pair.
Spread = ASK price - BID price
Let us try to understand this with the help of an example. Let us assume that you live in Europe and someone just gifted you $5000 through western union. And now you want to convert it into a different currency(euro). So, you went to a nearby western union office and ask them the rates. The price which the broker offers you to buy your base currency(dollars) in exchange for euros is the bid price.
Now, let us assume that this time you have to send $5000 to someone living in the USA. For that, you need to buy USD. So, you went to western union again, but this time to buy dollars in exchange for euros. So, the price which the broker offered you is the ask price. In simple terms, the bid price is the broker's offer to buy your dollars and ask price is the brokers offer to sell his dollars. And the spread is the difference between the bid price and the ask price.
Types of spread
1. Fixed spread
As the name suggests, fixed spread does not change with the different fluctuations going on in the market. It is the spread which is provided to you directly by your broker and hence is not influenced by the different market conditions.
It is not affected by the market timings, volatility or any other market fluctuations. Though there can be change in the quotes of the currency pair from time to time, but the overall spread will remain the same.
What is the use of fixed spread?
A fixed spread is for traders who are constantly active in the market. The traders who use a scalping strategy or day trading strategy and have to get out of the trade several times a day use fixed spread. Moreover, a fixed spread is mostly used by news traders as the spread doesn't change with the change in volatility during the time of news. Fixed spread is also benificial for a trader who is a beginner in forex trading and is about to try live trading with smaller account. Fixed spread is very benificial for smaller accounts.
Advantages of fixed spreads
1. Easy news trading
News trading gets a lot safer and easier while using fixed spread. This is because during the time of news release there is a lot of volatility in the market and floating spread will mostly take your stop loss by widening the spread during the news release. The price wont even reach the level of your stop loss and yet you be stopped out due to the widened spread. But, with the fixed spread, the spread remains the same no matter what and hence allows you to do news trading easily.
2. Provides transparency
In forex, many brokers try to manipulate the spreads in their favor to make you lose money. Many times brokers manipulate the spread just to take out your stoploss and makes you lose money. So, a fixed spread cannot be manipulated no matter what the conditions are and hence it promotes complete transparency.
3. Knowing commissions in advance
Using a fixed spread doesn't give you any quick surprise as you know in advance what the spread commission is going to be. And so it allows you to manage your trades in a better way. There is a clear transparency of the spread commision which you are gonna be charged by your broker.
2. Floating spread
A floating spread is also called as the variable spread due to its constantly changing value of the ask price and the bid price. As the name suggests a floating spread is a spread that changes from time to time with respect to the different market conditions such as increased volatility due to supply-demand levels or a news release etc.
What is the use of floating spread?
Every trader except the scalpers and news traders can use floating spread. This is because scalpers aim for a small profit and if the spread widens which usually does, it can convert your small profits into losses very quickly. News traders experience the same problem, as during a news release the floating spread is widened and hence can stop you out without the price moving anywhere near your stop loss. Floating spread is mostly used by the day traders and the swing traders with huge account size who doesn't really care about the spread.
Advantages of floating spread
1. No re-quotes
You won't experience requotes while using variable or floating spread. This is because in floating spread the price value changes due to the change in market conditions and not by the broker.
2. Tight spreads
Floating spreads often provide you with tight spreads when there is a lot of volatility in the market. During the time when their is lot of trading activity going on in the market and so the volume is high you will get very smalland tight spread and it can be very useful for your to make and save some money trading during these times.
Fixed spread vs floating spread
As by now you have learnt what a spread is and the different types of spread. Fixed spread and floating spread both are useful depending upon your trading style and account size. If you are a scalper or a news trader with small account size, you can choose fixed spread. Because you can easily calculate the commision you are paying and you know it wont change. Also, the fixed spread does not widen during news release or due to any other reason, so fixed spread is more preferable.
If you have a larger trading account and are a swing or a day trader, then floating spread wont bother you and can save you money. Overall fixed spread is better and will save you a lot of money on a long term. Just make sure that the broker providing the fixed spread is legit and lets you withdraw your profit time to time.
How to calculate spread?
When you subtract the bid price from the ask price, you get the spread of the respective currency pair. So, Spread = Ask price - Bid price
Let us take an example to understand this correctly. Below image shows the Ask price and Bid price of chart USD-CHF.
Here, the bid price is 0.98033 and the ask price is 0.98057. So, to calculate spread we need to subtract the bid price from the ask price.
Spread = 0.98057-0.98033
Therefore the value of spread in pips is equal to 2 pips and 4 pippette. Or approx 2 pips.
Let us take another example , The second pair in the image is GBP-USD.
Here, the bid price is 1.31096 and the ask price is 1.31122.
Spread = 1.31122 - 1.31096
= 2 pips approx.
Now, the cost value of the spread depends upon the lot size you are using. If you use a lot size of 0.10 and the spread is of 2 pips then you will be charged $2 for opening the trade.
For example, as we calculated the spread on USD-CHF in the above example. Consider you used 4 mini lot size for opening a trade, which is lot size 0.40 or 4*0.10. So, here the spread charged by broker was 2 pips approx.
Spread cost = Value of spread in pips * value of pip on lot size used.
= 2 * 1(4) As we used mini lot, 1 mini lot is $1 per pip.
You will be charged $8 by the broker when you open a trade.
What influences spread?
Popular currency pairs are traded with lowest spreads while other pairs have a larger size of spread, this is due to the liquidity of those currency pairs. Spreads on major currency pairs is always low when compared to the other rare currency pairs.
When there is more volatility in the market, the spread is usually very tight. This is because more volatility means more volumne which indicates that there is a large number of orders being placed and hence a tight spread is provided.
3. Competition between brokers
Nowadays the competition between the forex broker has increased a lot and every broker wants their customers to stick by their side and hence they try to provide the lowest possible spreads to keep their customers happy and also attract more customers.
What is the purpose of spread?
When you first started looking for a broker, you must have came across some broker who claimed no commission or zero commission on the trade you place. Yes, they indeed dont charge any commissions on the trade you place.
But for a moment try to think? how they provide you with all the services which you are enjoying? It is obvious that they would need money to provide you such pretty services. right? Such brokers who promise you no commission make their money through spread. Simply, instead of charging you a commission fee they charge you through a different medium called as spread.