You may have heard of “no commission” or “commission-free” brokers. These brokers let you trade on their platforms without any transaction fees.
But no platform is ever truly without a cost. Commission-free brokers often generate revenues through spreads.
Lesson Highlights
- The difference between the bid price and the ask price is called the spread.
- Brokers often generate profits through the bid/ask spread.
- Spreads can be classified into two types: fixed spread and variable spread
- Spreads are affected by different factors, including market volatility, currency pairs, trading hours, and brokers.
What Is a Spread?
When you trade currencies, brokers will quote you two prices. One of these prices is the bid price, while the other is the ask price. The difference between these two prices is what we call the spread.
Also called the bid/ask spread, it is often interchanged with the broader term “transaction cost.” It is a built-in fee mechanism that lets brokers make money from every trade you make.
But how do brokers make money from spreads?
When you trade in a broker’s platform, you “buy” the currencies from them. Brokers sell you these currencies at a higher price than they bought them. Conversely, when you sell currencies, brokers buy them at a price lower than your original buying price.
Brokers pocket the spread or the difference in the prices.
How to Measure Spread in Forex
To measure spread, you must calculate the difference between a currency pair’s bid and ask price.
Suppose you’re buying USD with euro. If the selling price (ask) is 1.1003 and your buying price (bid) is 1.1005, the difference (0.0002 pips) will be the spread.
Spread is expressed in pips, which, as you already know, is a unit of measurement of currency prices.
For most currencies, prices are quoted up to four decimals. The Japanese yen is an exception, quoted with only two decimals.
Thus, most currencies will display a 3-pip spread as EUR/USD 1.103/1.1006, while a 3-pip spread involving the Japanese yen will be shown as EUR/JPY 140.03/140.06.
Types of Forex Spreads
You will likely encounter two types of spreads when trading: the fixed spread and the variable spread. Brokers operating as market makers usually offer the former. Brokers with a “non-dealing desk” model provide variable spreads.
Fixed Spread
As the name implies, fixed spreads are a static value. Regardless of market conditions, fixed spreads will remain the same throughout trading sessions.
Brokers that offer fixed spreads are often market makers with a “dealing desk” model. This means the broker typically purchases large positions from liquidity providers (e.g., large commercial banks) and provides traders with smaller-sized positions.
This essentially makes brokers their clients’ counterparty in trades.
Variable Spread
In contrast with fixed spreads, variable or “floating” spreads are subject to constant change. Brokers offering this type of spread get their prices from several liquidity providers. They relay these prices to their clients without going through a dealing desk.
Generally, bypassing a dealing desk means the brokers do not control spreads. Instead, spreads widen or tighten depending on supply, demand, and market volatility.
Calculating the Spread Cost
Calculating spread cost is pretty straightforward. You only need to know the pip value, spread, and position size.
Let’s say you want to buy one standard lot of U.S. dollars using euros at an exchange rate of 1.14002.
We’ve already covered how to compute the value of a pip in previous lessons, but just in case, let’s go over it again.
The pip value formula is:
Pip value = (one pip / exchange rate) * lot size
This means the pip value for the EUR/USD = 1.14002 is USD 8.77.
Assuming that the EUR/USD spread is 2 pips, and the formula for calculating spread cost is
Spread cost = spread position size pip value
Then
2 pips 1 lot 8.77 pip value = 17.54
The spread cost will be USD 17.54. This means you incur this amount as a trading cost for every trade.
Factors Affecting Forex Spreads
As you've learned in the “variable spread” sections, spreads can be subject to change. Different factors can impact how much spread a currency pair has.
Some examples of forex spread determinants include:
- Market volatility. Spreads tend to widen when markets experience periods of volatility. Market makers typically widen spreads to compensate for heightened risks in response to the increased liquidity demand.
- Liquidity. Highly liquid currency pairs (e.g., EUR/USD and GPB/USD) tend to have lower spreads. The large volume of available traders for these pairs makes it easier to find buyers and traders and keep spreads low.
- Trading hours. The time you trade can affect the spreads brokers offer. For instance, trading between 8 AM EST and 12 PM EST narrows the GBP/USD spread. This is due to the overlap between the New York and London trading sessions. The overlap creates a window of increased trading activity.
- Brokers. Different brokers offer different spreads. To find the most competitive spreads available, you will have to check several brokers and compare the spreads they offer.
The next lesson will help you become more familiar with the various forex jargon. Hopefully, it can aid you in future lessons, too!
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