What is the spread?
The spread is the difference between the bid price and the asking price in Forex. In other words, it’s the difference between the sell and the buy price.
The price on the left is the bid price, which is the price that the dealer is prepared to buy currency from a trader, and the price on the right is the ask price, which is the price that the dealer is ready to sell a currency to the trader. So a trader will buy at the ask price and sell at the bid price. The difference between the bid price and the ask price is the spread and is measured in percentage interest points or PIPs.
Implications of the Spread
What are the implications of the spread and what is the financial value of the spread?
On the trader’s end, the spread is part of the cost that is contracted in executing trading transactions. Different currency pairs and assets have separate spreads. Generally speaking, the more liquid a currency pair is, the lower the spread. Liquidity is a function of how many active traders from all over the world are actively trading the currency pair. Liquid pairs have lower spreads, but a more limited range of movement. Illiquid pairs tend to have larger spreads and more range of movement.
On the broker’s side of the equation, the spread is the profit earned for providing the Forex trading service. In extension, brokers also pay their introducing agents and affiliates from the spreads of the traders that these agents have recruited into their platform.
Financial Value of the Spread
The lot size and the number of pips that make up the spread will determine the financial value of the spread.
A standard lot is worth $10 per pip ($100,000 trade value size X 0.0001). Accordingly, if a trader is trading a currency pair with a spread of 3 pips on a standard lot, the financial value of the spread is $10 X 3 = $30.
Knowing the value of the spreads for a currency pair will help a trader balance out risk by using the appropriate trade sizes, or selecting currency pairs with reduced spreads to save cost.
Problems with the Spread
There are times when spreads may extend surprisingly, even on platforms that offer fixed spreads. When there is critical market volatility with lots of traders pushing to get into positions, some traders may be filled at prices which make the spread a lot wider and more expensive for the trader. Such an event could happen when there is a high impact news item such as the NFP (US Non-farm Payroll report), or when there is a natural disaster or terrorist attack which causes panic in the financial markets. Even when pending orders are used, this problem could still occur.
The only way to prevent this is to use an ECN platform. Usage of an ECN broker will also attract commissions in addition to the spreads that the trader pays. However, the virtual non-existence of the slippage event compensates for the increased charges.