Spread is a fundamental aspect of trading, representing the difference between the bid price and the ask price of a financial asset.
Understanding spread in trading and its implications is crucial for new traders, as it helps with understanding transaction costs and making informed trading decisions.
In this article, we take a close look at what is spread in forex trading, and explain what new traders need to know about forex spread.
What is spread in forex trading?
The ‘spread’ in fx trading refers to the difference between the bid price and the ask price of a currency pair.
It is always expressed in pips, which is the smallest unit of measurement for currency pairs.
When looking at a quote for forex, the bid price is always on the left, and the ask price is always on the right.
This is what the bid price and ask price represent:
- Bid price: the price at which a broker is willing to buy a currency pair from you
- Ask price: the price at which a broker is willing to sell you a currency pair
When trading forex, the bid price is the cost of buying the base currency, which is the first currency mentioned in a pair.
The ask price is the cost of selling the base currency.
The spread between two currencies is represented by the last one or two decimal points in the quote.
Here’s an example of a 0.7 pip spread in a quote for EUR/USD.
The spread is calculated by working out the difference in price between the bid price and the ask price. To do this you subtract the bid price from the ask price.
Below is an example of a quote for USD/JPY. Notice there are two less decimal places on this quote?
That’s because the Japanese yen has a lower value compared to the US dollar, and so movements in the exchange rate beyond the second decimal point are much less significant.
Quoting to two decimal places is sufficient to capture the small spreads and price movements in this highly liquid market.
The practice of quoting USD/JPY to only two decimal places has become a market standard over time.
The yen is the only currency that is quoted to just two decimal places, with the remainder quoted to four places (or five if you include pipettes.)
Where does the spread come from?
To really understand spread, it is necessary to understand a little more about how the forex market works.
The spread isn’t simply a fee invented by brokers. It arises from the very nature of the forex market.
Forex operates on a decentralised network, without a central exchange.
Liquidity providers, which are large financial institutions like banks and investment funds, constantly quote bid and ask prices for currency pairs.
These prices are streamed out electronically to smaller retail brokers. These prices are a reflection of:
Supply and demand
The bid price represents the price the provider is willing to buy a currency at (based on demand), while the ask price represents the price they’re willing to sell it at (based on supply.)
Risk management
Liquidity providers incorporate a markup between the bid and ask price to account for potential market fluctuations, and to help manage their own risk.
The spread, therefore, is essentially the payment that liquidity providers receive for facilitating worldwide forex trades, and assuming a level of risk.
To understand spread, think of it in terms of going to the supermarket to buy fresh produce.
The big liquidity providers are like the vegetable growers, who grow produce in bulk and then offer to supply those vegetables to multiple supermarkets (who are the retail forex brokers.)
The growers have to charge the supermarkets a price which covers their costs of growing that produce.
This is the liquidity provider’s spread.
In turn, the supermarkets have to make a profit too, or else they wouldn’t exist to supply fresh food to consumers.
Therefore, some retail forex brokers add their little bit of profit onto the price as well, adding more to the spread.
The spread of liquidity providers, plus any additional spread added on by some retail forex brokers, is what you will see as a forex trader.
However, MarketMates is different from some other brokers, as we don’t charge a markup on spread, swap, or commission. Instead, we offer subscription-based trading.
Different ways of pricing spread
There are two different ways of charging spread:
Fixed spread: In a fixed spread model, the difference between the bid and ask prices remains constant, regardless of market conditions. For example, a two or three pip spread may be charged across all trades.
Variable spread: Also known as floating spread, this type of spread fluctuates in response to market volatility and liquidity.
When retail forex trading first started, which was in the late 1990’s, the fixed spread model was common.
However, these days, as the retail forex market has matured, a variable spread system has become the norm.
Different forex broker pricing methods
There are three different ways that retail brokers can make a profit. Here are the three main ways:
1. Spread markup model
Adding pips: Many retail brokers take the spread quoted by liquidity providers, and then add on additional pips to it. This additional ‘spread markup’ represents their commission for executing your trades.
2. Commission model
Direct commission charge: Some brokers opt for a commission-based structure. They charge a fixed fee per trade (called commission) on top of the spread quoted by liquidity providers.
3. Subscription-Based Trading
Subscription-based trading: Here at MarketMates, we are offering a new way of trading. We offer a subscription-based trading service. In return for a small monthly subscription, you get to trade with no markups on the spread that we receive from the large liquidity providers.
In essence, our subscription-based trading service (SBT) means you pay the wholesale price for your fresh food, without having to buy in bulk like supermarkets do.
How liquidity providers determine the spread
Liquidity providers play a crucial role in determining the spread you see as a retail forex trader.
Highly liquid currency pairs, like EUR/USD, have tighter spreads, because numerous liquidity providers are vying to offer competitive prices, driving the spread down.
However, during periods of high market volatility, liquidity providers might widen the spread to hedge against increased risk.
This ensures they have a larger ‘buffer’ to absorb potential losses if market prices move unexpectedly.
In essence, liquidity providers act as the middleman, setting the foundation for the spreads that retail forex brokers charge.
Spread differs depending on the currency pairs you choose to trade
As explained above, highly liquid forex pairs are offered by liquidity providers at a lower price. We say they have ‘tighter’ spreads.
Conversely, if the currency pair is traded less often, and there is less liquidity, the spread will be ‘wider’ or more expensive.
Therefore, it makes sense that the major currency pairs have tighter spreads than the exotic currency pairs, simply because there is more liquidity in the market for the majors.
You can think of this like the price of common vegetables (like potatoes) being more competitive than an exotic vegetable, such as asparagus or artichoke.
In the same way, major currency pairs have tighter spreads and are cheaper to buy than exotic currency pairs.
What causes the spread to change in forex trading?
There are many factors that cause the spread to change in a forex transaction. These can include:
Market liquidity: The spread tends to widen during periods of low liquidity, such as after market close, during holidays, or when major financial centres are offline. During these times, there are fewer market participants, leading to wider spreads as liquidity providers adjust their pricing to reflect the increased risk
Economic events: Major economic events, such as central bank meetings, interest rate decisions, GDP releases, or employment reports, can cause volatility in the forex market and lead to fluctuations in spreads. Traders may anticipate increased volatility ahead of such events, causing spreads to widen as liquidity providers adjust their pricing to manage risk
News announcements: News releases, especially those related to geopolitical events, trade negotiations, or unexpected economic data, can impact market sentiment and lead to sudden changes in spreads. Wise forex traders closely monitor news feeds and economic calendars for potential market-moving events that could influence spreads
Market sentiment: Changes in market sentiment, driven by factors such as investor confidence, risk appetite, or geopolitical tensions, can affect trading volumes and liquidity. During periods of heightened uncertainty or risk aversion, liquidity providers may demand higher spreads to compensate for increased risk, leading to wider spreads
Trading activity: High trading volumes and order flow can impact spreads, particularly during peak trading hours when multiple financial centres are active simultaneously. Increased trading activity can exhaust liquidity at specific price levels, causing spreads to widen temporarily until liquidity providers adjust their pricing.
What is slippage?
There will be times when the forex market is volatile, and prices are rapidly changing.
Consequently, when attempting to execute a trade at a specific price, your broker may be unable to fulfil the order at your desired price point.
Instead, they may offer a new price, a process known as ‘re-quoting.’
So, if you try to enter a trade at a specific price, the broker will ‘block’ the trade and ask you to accept a new price.
You will be ‘re-quoted’ with a new price.
The requote message will appear on your trading platform, letting you know that the price has moved, and asking you whether or not you are willing to accept the new price.
(Hint: It’s almost always a price that is worse than the one you ordered.)
This is known as slippage – when you are unable to get the price you requested to enter or exit a trade.
As a result, the price at which a trade is executed may differ significantly from your intended entry price, leading to an unfavourable outcome and a more expensive trade.
If you would like to know more about brokers and market-makers, read my article here about are market makers good or bad.
Till next time,
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Sources
Marketmates uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial guidelines to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
- Investopedia – Spreads in Finance. https://www.investopedia.com/terms/s/spread.asp
