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Spread - What is a Forex Spread and how does it Work?

January 2021

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One definition of a spread is the difference between the best bid price that a dealer is willing to pay for a currency (or other trading instruments) and the ask price that a dealer is willing to sell the same currency. These are sometimes referred to as the bid-ask spread, the buy-sell spread, the biding price and the asking price; and brokerage commission.

If a broker is just an intermediary, how then can the spread be its commission? Why does each brokerage company have different spreads? And why do some brokers offer a zero spread? Also, how does a broker make money then? You will find the answers to these questions and many more in this review.

What is a Forex Spread: How Does it Work
The following issues are addressed:
  • What is a spread at the stock market and in trading? What is a markup and how is it different from the spread?

  • Classifications of spreads.

  • Factors affecting the amount of trading costs.

  • How to choose a spread and why it should be taken into account when creating a trading strategy.

  • How to choose a currency pair depending on the size of a spread.

  • Spread in the stock market.

  • Methods of reducing trading costs.

  • Brokers with minimal spreads.

It will be useful and interesting!

What is a spread in the stock market? What is a markup and how does it differ from the spread?

The spread is the difference between the best asking and bidding prices of an asset at a given moment.

Example:

Imagine a site with sellers on one side and buyers on the other. The trading asset is pears per kilogram. Each of the participants in the transactions sets his own prices at which he is ready to sell or buy 1 kg of pears. One seller is ready to sell pears for US$15, the second one offers to sell at US$14, and the selling price offered by the third trader is US$13 per kg. In turn, one buyer is ready to buy pears for US$10, the second buyer offers US$9, and the third is willing to pay only US$8. The best selling price is US$13, and the best buying price is US$10. Therefore, US$3 is the spread.

This site can be figuratively called a market depth. A market depth or an order book is an instrument where all bid orders and asking orders are displayed. And, once again, the difference between the best prices is the spread of the transaction.

How a broker makes money on a spread

Recall the three models of client orders processing:

  • A-Book.

    A client’s transactions are sent directly to the external market, and the broker in this scenario acts only as an intermediary.

  • B-Book.

    These are orders made by traders that are not sent directly to the external market but are executed within the brokerage system using overlapping. The counterparty in this scheme is a broker itself, which consolidates the orders. Accordingly, it forms the spread, which in this case is the broker's fee (commission). Currency exchange offices operate under the same principle. In other words, they buy currency at a lower price and sell it at a higher price. The spread or margin is their profit.

The second scheme has two options: sending transactions directly to the liquidity providers (most often these are the largest investment banks) or to the ECN system (for example, Integral or Currenex). In the first case, the amount of commissions is formed by the supplier itself. Suppliers compete with each other, trying to offer the smallest differences between the bid/ask price. In the second case, the size of the commission is set by the market. The ECN system aggregates all orders and ranks them from the best to the worst. This is how the market spread is formed.

A markup is an extra charge added by brokers to a spread. It serves two purposes:

  • 1

    This is part of a broker's profit. A trader sees the final amount of the commission in the platform, which is the market component and the markup.

  • 2

    This is a tool for regulating the trading conditions of the liquidity providers, which are charged to brokers following the commission agreements.

Brief summary of what constitutes spreads

A spread of rates is the difference between the bid and ask prices. Its final value, which a trader sees, is the price difference formed by the supply/demand or by the liquidity provider + the markup, a broker's commission charge.

Types of a spread

  • Fixed

    The figure (for a particular trading instrument) is indicated in the trading conditions and remains unchanged during the trading session. The fixed spread seems more attractive because a trader always knows the size of his trading costs, based on which he builds a trading strategy or system (sets when he takes profits, stops, etc.). However, a broker has the right to change its size depending on the level of volatility. Therefore, it is fixed only conditionally.

  • Floating

    A floating or variable spread can change arbitrarily depending on the market situation. The market spread is formed by the ratio of order volumes, that is, the ratio of supply and demand. The greater the liquidity of the asset, the greater the volume of orders. Consequently, the smaller (narrower) the spread becomes.

Factors affecting the size of a spread

The following factors affect the size of a spread:

  • Asset liquidity.

    The larger the trading volumes, the lower the trading costs;

  • Volatility.

    When there is an increase in volatility due to an uptick in market conditions, a sharp imbalance between the bid and ask orders accrues, which causes spreads to widen;

  • Broker's trade policy.

    Brokers have the right to change the amount of their markup (extra charge). For example, to weed out traders working on algorithmic scalping to reduce the load on its servers;

  • Level of business activity.

    For example, at night, the activity of trading in European currencies decreases and, conversely, increases in Asia;

  • Types of account.

    There are brokers with fixed spreads, and there are professional ECN accounts with the smallest spreads, but each lot will have its own fixed commission.

Factors affecting the size of a spread

How to choose a type of spread and how to assess its influence on the trading system

A spread is a commission that directly affects the performance of a trading system. This point is especially important during scalping. The spread can sometimes widen to 3-5 pips (percentage in points), while the very essence of scalping is high-frequency trading while taking profits based on the pips. Therefore, some brokers specifically set a high spread to control scalping.

👍 Advantages of floating spreads

  • • It is minimal. Some spreads range from 0.1 pips. For comparison, fixed spreads range from 2 pips and up. It is low most of the time;
  • • In theory, a broker does not affect the size of the spread, since transactions are sent directly to the external market. But don't forget about the broker’s markup;

👎 Disadvantages of floating spreads

  • • The floating spreads are most often found on the ECN accounts with a fixed commission;
  • • During a time of high volatility, the spread may widen significantly. A broker can also take advantage of this temporary situation because a trader will not be able to prove that the broker intervened and added a quick markup;
  • • Slippage. Sometimes a trader will see a price that suits him and immediately sends an order. But due to the normal delay (lag time) and time required for the order execution, the price may change for the worse;
  • • Requires constant monitoring;
  • • The inability to test the strategy, since the spread value cannot be specified in the tester causing an unreliable result.

👍 Advantages of the fixed spread

  • • It does not change — at least during the session. A trader knows in advance the size of his trading costs and can use this as a starting point when formulating a trading strategy or setting a take profit point.

👎 Disadvantages of the fixed spread

  • • During a calm market, the fixed spread is noticeably larger than the floating spread.
  • • A broker can change the amount of a floating spread unilaterally.

What is a zero spread?

What is a zero spread?

This is a marketing technique used by brokers to attract traders. The wording “spread from 0 pips” means that a broker is ready to provide the minimum difference between the bid and ask prices, but it is never zero, even if we are talking about the instant order execution. In theory, depending on the asset and the liquidity provider, the spread in currencies can be equal to 6 decimal places, and the broker may round it down to five-digit quotes. Only then does a trader really get a zero price difference but this rarely occurs in practice.

Where to find the spread rate in MT4?

Step-by-step guide on how to find the spread in MetaTrader 4:

  • 1

    In the order.

    The spread here will be the zone between the quote lines or the difference between the bid and ask prices.

  • 2

    To display the ask price on the chart, right-click on the chart, select the Properties item, go to the General tab and check the corresponding option.

  • 3

    In the specification of the contract. In the Market Overview window, right-click on the asset, select the Specification item. The type of spread is indicated there. In the same menu, check the Spread box, and information on it is now displayed in the Market Overview window.

How to choose a currency pair depending on the size of a spread

Classifications of currency pairs depending on a spread:

  • The major currency pairs are the most liquid currency pairs with high trading volumes. They include EUR/USD, GBP/USD, JPY/USD, CAD/USD, NZD/USD, and CHF/USD, where the spread is the smallest;

  • Currency pairs with lowest spreads
  • Pairs with an average spread. Here the spread can be 1.5-2 pips, so it is better to select the points of transaction opening as accurately as possible, picking up the beginning of the trend;

  • Pairs with the maximum spread. This applies to "exotic" instruments. For example, pairs of developing countries (Pakistan rupee, South African rand, etc.). Due to the lack of trading volumes for them, the spread is the highest among these.

Spread at the stock market

Spread at the stock market

Everything mentioned above is the spread in the order book. It is also present in the stock market. For example, if a stock share can be bought for US$1200, and sold for US$1000, then the spread is US$200.

There is also another type of spread at the stock market — the difference in the prices of derivatives for the same underlying asset, but with different execution terms. For example, the difference in price between oil futures with contract executions in June and September. Futures spreads are traded on global stock exchanges.

Methods of reducing a spread

Since the size of a spread does not depend on a trader, there are few options for reducing it but the following suggestions may help:

  • 1

    Choose accounts with the smallest spread. To do this, use comparative tables of the independent resources (see below), compare trading costs using demo accounts, etc. Note that accounts with minimal spreads usually have a commission per lot and a high entry threshold.

  • 2

    Select the most liquid assets with the highest trading volumes. For them, the difference between the bid and ask prices is minimal.

  • 3

    Do not trade when important market news first breaks because that is when the spread is most likely to widen for accounts with the floating spreads.

  • 4

    Use rebate services. Spread refunds (i.e., rebates) are a free service that allows you to partially offset trading costs. The advantages of a rebate service are:

    • a trader does not bear any costs for the rebate service. The service is free of charge without fees or commissions;

    • a trader reduces costs by partial compensation of the spread;

    • a trader receives legal and informational support of the rebate service.

The partial rebate of the spread is an analog of the classic cashback. A trader chooses a rebate service (there are only a few), goes through free registration, and opens an account with any broker from among the service partners using the partner’s link. There are no problems with choosing a broker because most rebate services are affiliated with several dozen brokers. For each completed transaction, regardless of the result, a broker pays the rebate service a commission (part of the broker’s profit), the rebate service, in turn, shares part of its fee with the trader.

Brokers with a minimal spread

Brokers with a minimal spread

If it were easy to rank brokerage companies by the size of their spreads alone, then some brokers would jump to the top of the rankings, while others would be bankrupt. After all, who will voluntarily agree to pay more if you can pay less? The problem is that the size of a spread does not always depend solely on a broker. Therefore, today one broker may have the lowest trading costs, tomorrow another one may. Also, a lot depends on fundamental factors that affect the liquidity of an asset at different times.

Some declare certain trading conditions but offer others. Some change “the rules as trading progresses." Often traders do not notice that their trading costs have increased. And those who still make claims receive a link to the offer, where everything is so confusing that it's easier to accept the prevailing conditions.

How to choose a broker: Forex spread comparison

  • 1

    Use third-party independent resources that constantly update and publish spread tables. For example, MyFxBook.

    MyFxBook: Forex Brokers Spread

    This resource is convenient because it is one of the leaders among information resources for traders. Here you can find information on dozens of brokers in Europe under the heading Currency Pairs and other instruments. There is a filter. The data here are averaged and do not take into account the section of accounts of a separate broker, so the numbers should be double-checked. However, this table is enough to create a general overview.

  • 2

    Оpen and compare the platforms of several brokerage companies, try to open transactions for one instrument at least on a demo account. You will immediately see the real spread. For example, below are two screenshots taken on a weekend (that is, when there was no trading):

    And the second screen:

    Contains not only the difference in quotes on a closed trading day but also the difference between the bid and ask prices, is immediately evident. The first broker has a difference in the 5th decimal place, the second — in the 4th. Which broker do you think is more profitable to work with?

  • 3

    Use spread indicators. These are simple, convenient scripts installed in MT4 through the data catalog. They show the difference between the bid and ask prices as a bar chart. They can be used to track the current difference, as well as its change in comparison with the history of the quotes. It is visually convenient.

  • 4

    When you see the spread value, specify what quotes are in question. The spread of 2 pips can turn into 20 pips in 5-digit quotes.

    Do not trust rating sites that try to convince you that they have compiled a rating of the best brokers for trading because many of the rankings — except for those by Traders Union — are subjective. Rather, it makes more sense to pay attention to trading forums, but opinions there may be biased too.

    Also, remember that the size of the spread depends on the type of account, asset liquidity, volatility, and broker’s liability. Try to build trading systems in such a way that the costs can be ignored. Don’t think about how to save money, but how to make money.

Good luck with trading!

About the author of this article

Mr. John Mayer graduated with a master’s degree in Data Analytics from one of the top business schools in the UK. Since then, for the last ten years, he has been working as an analyst in the foreign exchange market.

During his time as an analyst, he has worked with several clients. His years of experience in the field led him to want to share what he has learned.

FAQs about the Forex spreads

What is a spread and what factors affect its size?

The spread is the difference between the best buy and sell prices of a trading asset. Also, the spread is a kind of commission that the broker charges to traders for their services.

How to choose a broker with the lowest spread?

To do this, use the available tools for choosing a broker from Traders Union. This tool serves for comparing brokers, as well as choosing brokers by parameters.

Rewards from Traders Union depend on the size of the broker's spread?

As far as brokers are concerned, the amount of additional payment from Traders Union depends on the size of the spread on the trading instrument. Top brokers make affiliate payments not in a fixed amount, but as a part of the spread.

What do you need to get a rebate (spread cashback)?

To receive a rebate on part of the spread, you only have to register on the broker's website using the Traders Union referral link and open a trading account using the partner code. After that, every day or monthly, depending on the broker’s conditions, Traders Union will transfer to your personal account a rebate for every trade, even a losing one. If you already have an account with a broker, then from these instructions you can learn how to add it to the Traders Union partner group to receive payments.