In the Forex market, the spread is the difference in pips between the bid price (purchase price) and the ask price (sale price) for a given currency pair such as EUR/USD. Spread is the way that many Forex brokers use to obtain benefits for each transaction that their clients (traders) make through their trading network in the market. For example, at any given time, a broker may be paying a price of 1.3500 to buy or sell EUR/USD; however, this same broker will allow its clients to buy the currency pair at 1.3501 or sell it for 1.3499.
As we know, the quoted price for any currency pair is expressed by means of the combination of the symbols of the two currencies that make up the pair and the bid and ask price as shown below:
Table of Contents
-Base Currency/Quote Currency | Bid Price/Ask Price
Thus, if at a given moment, the price for the euro against the US dollar is equal to 1.3500-1.3502, this price is expressed as follows:
-EUR/USD = 1.3500/1.3502
Bid is defined as the maximum price at which the market is willing to buy, which is why it is also recognized as the purchase or demand price. Therefore, it is the price at which the trader will enter the market if he is selling the currency pair.
Ask is defined as the minimum price at which the market is willing to sell, which is why it is also identified as the sale or offer price. Therefore, it is the price at which the trader will enter the market if he is buying the currency pair.
The difference between the Bid price and the Ask price is what is known as the spread. The spread is expressed in points, and in the case of the Forex market in pips. In the case of the previous example, the spread for the EUR/USD is 2 points or pips.
How do spreads work?
To better illustrate what spreads consist of in the Forex currency market, we will use the following example:
Suppose an investor wants to open a buy position on the EUR/USD pair at a price of 1.3401. Immediately the broker with which this trader operates will satisfy the request of his client and carry out the purchase operation on his behalf, with the difference that the broker will probably buy the EUR/USD at 1.3400 (or even 1.3399 for this operation, depending on the market conditions and its liquidity providers), obtaining as profit for the transaction 1 pip. Now suppose that the trader wants to close the position and sell immediately (assuming that the price of the currency pair has not changed) for one reason or another; In this situation, it will only be able to sell at 1.3999, since we must remember that now the broker is selling at 1.3400, but it charges a 1 pip in the spread as profit from the operation.
For this reason, to obtain profits when trading in the Forex, it is necessary to surpass the spread over the price with an advantage. Otherwise, the balance of the operations will remain at zero or even be negative in the event that the trader closes the position at entry price. This is of utmost importance in currency pairs that generally have a high spread, as in the case of AUD/JPY, whose spread can reach 8 pips depending on the broker.
Why is it important to understand the topic of spreads?
One of the biggest difficulties regarding the issue of spreads in the Forex market is to really know how much the broker we have hired for the service is charging per operation and if this charge is really fair.
Something that many beginning traders and investors do not know is that it is possible to manipulate spreads on the trading platform without the clients realizing it, and there are brokers led by unscrupulous people who use this practice to increase the advantage over their clients and obtain greater Profits. Because the Forex market is not fully centralized or regulated, this practice is observed more frequently than it should be.
For this reason, it is necessary that the trader selects brokers who have a good reputation and who have never been accused of price manipulation. Although it is not an absolute guarantee, it is also recommended to operate with a broker regulated by a major financial regulatory body such as the Financial Conduct Authority or CySEC, as these entities require companies to meet strict requirements regarding the financial services they offer, especially in terms of equity and quality.
Even in the case of brokers that do not perform any undue price manipulation, the issue of spread is important since it represents the highest cost for the trader. A trader that operates with a broker that charges low spreads will have less costs in their transactions, and in the long term, this will mean a very important saving. On the contrary, if a trader uses the services of a broker with high spreads, he will have to generate higher profits in his operations just to offset the effect of the spread.
For many traders, the spread can be the difference between making a profit or a loss. For example, if a trader performs many short-term trades (of a few minutes) daily, the spread may end up absorbing his profits, especially if he trades with a broker characterized by high spreads, and his trading profits are low. In the case of traders who carry out long-term operations that generate many profit pips, the spread is of little relevance since it has little impact on the results of their transactions.
How to select the most convenient broker based on spreads?
When selecting a broker to operate in the Forex market, several criteria must be taken into account, including the spread. As indicated above, the impact of the spread on the costs of the trader depends on the frequency of operations, the duration, and the average profit that the trader obtains in his transactions. In this way, a trader who trades very frequently and gets few pips in each trade should look for a broker that charges the lowest spreads in the FX market so that their profits are not precisely diluted by the effect of the spread. In this case, it is best to open an account with an ECN broker, since these are characterized precisely by their extremely low spreads, although it must be taken into account that in many cases these companies obtain their benefits by charging commissions for each transaction.
The STP brokers also offer good trading conditions regarding spreads, thanks to its liquidity providers and operating systems. With respect to Market Maker brokers, spreads are generally higher, and since these companies act as the trader’s counterparty, there may be conflicts of interest and, in some cases, even price manipulation. However, Market Makers offer fixed spreads for most of the time, which may be advantageous for some traders.
Likewise, as mentioned in the previous section, another recommendation is to select a broker that has a good reputation, and above all, that does not have accusations or complaints about fraudulent price management. If the selected broker is regulated, even better for the trader as this provides a higher level of security.
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