Decreasing the Exchange Spread: What Does it Mean for Traders?
When you first start looking for potential Forex brokers, you might notice that some of them take commissions for executing every trade while others claim to offer zero-commission services. In most cases this means that, instead of charging commissions, brokers implement so-called exchange spreads, which can help to keep transactional costs to a minimum.
In this article you will learn more about what exchange spreads are, how they are calculated, and whether exchange spreads can be decreased.
What is a spread?
When you trade Forex, you usually do it through an intermediary — a broker, who sells and buys currencies to and from traders. Since traders don’t trade on the Forex market directly but use the services of brokers, there’s a difference between the price at which a trader sells a currency and the price at which a trader buys it. This difference is called a spread.
For example, if you exchange currency at a bank, you will see that the price the bank is offering to sell the currency to you is higher than the price it is ready to pay in order to buy this same currency from you. This difference between the buy and the sell prices is what a spread is, and it’s the profit the bank and brokers who use this type of trading fee get from transactions.
How is a spread different from a commission?
Both traditional commissions and spreads serve the same function — payment for a broker’s services. However, they work quite differently.
Spreads are included in the price quoted to traders when they first enter a trade. Spreads can be fixed and flexible. The difference between the two is that flexible spreads can be adjusted by the broker depending on the current market conditions while a fixed spread stays the same regardless of them. Another thing to remember is that you have to pay a spread once per trade.
As for commissions, they’re charged by the broker as an additional cost and aren’t included in the quoted price. Most often, commissions are fixed, meaning that you will have to pay the same amount for low- and high-volume trades. Commissions are also charged twice per trade — both when you enter and exit it.
Which option is better for you depends on your trading style and personal needs. However, most Forex traders prefer using spreads as they can be adjusted and offer more profitable opportunities for traders.
How are currencies quoted?
Trading Forex means buying one currency while selling another. In other words, Forex trading involves trading currency pairs, which are indicated on the charts as USDCAD or EURUSD. The first currency in a pair is called the base currency, while the second one is the quote currency.
When a currency pair is quoted, the price you see represents the amount of the quoted currency required to buy one unit of the base currency. For instance, if USDJPY is trading at 134.2600, it means that it will cost you 134.26 Japanese yen to buy $1 U.S. dollar.
How to calculate the spread?
Knowing how the currency pairs are quoted can help you identify how much spread you will have to pay. If you look at the ask and bid prices of a pair, you’ll notice that they’re different. So to calculate the spread you need to subtract the bid price (the sell price) from the ask price (the buy price).
So if GBPUSD is trading at 1.2102/1.2105, the spread will be calculated as 1.2105 - 1.2102, equalling to 0.0003 (or 30 points).
Fixed and floating spread
As you already learned, a spread can be fixed or flexible (floating).
A fixed spread stays the same even if the market conditions change. This can be an advantage in volatile markets or if a trader is a beginner because the transactional cost stays the same and there’s no danger of it exceeding the profit. However, a fixed spread can be requoted unexpectedly and without notice, which can interfere with your trades.
A floating spread gets adjusted when the market conditions change. It can tighten when there isn’t much action happening on the market and widen when the volatility gets high. A floating spread depends on the levels of supply and demand of currencies, so when you’re expecting a lot of market action (for example, after economic data releases or other major events), you should be prepared for a bigger spread. Trading volatile spreads can be dangerous for beginners as the transactional costs can easily exceed the overall profit from the trades. But they provide more transparency to trading and allow you to see what you’re really paying for.
How to trade with a low spread?
For traders, it’s much more profitable to trade when the spread is tight. The less money you spend on transactional costs, the more money you will be able to invest in your trades, increasing your overall profit.
The main reason behind tight spreads is high liquidity. When the market experiences a surge in traded volume, the spread generally stays very tight. If a Forex pair is very popular among traders, it’s easier for them to buy and sell it, turning their purchase into profit. The more a currency pair is traded, the more spread a broker receives. But if trading is going slow and the liquidity is low, a broker won’t get much returns if it keeps the spread amount tight, which causes the increase in the amount of spread potential traders have to pay.
There are several factors contributing to high liquidity on the market:
- Time of the day. The Forex market is open 24 hours during the weekdays, which means you can continue trading at any time. However, there are certain limits when it comes to trading currencies that not many people take into account. For example, the European and Asian Forex markets become active during the standard working day hours, which do not overlap. This means that if you’re trading, say, a Japanese yen when the Forex market has already moved on to a European trading session, you won’t see much liquidity, meaning the spread for JPYUSD will be much higher than for the European-based currency pairs.
- Volatility. When the market is volatile, the exchange rates can fluctuate randomly as well. Because of this, the spread will likely become even wider to compensate for the lack of stability on the market and to match the constantly changing supply and demand levels. This is why trading in volatile markets when you’re trying to cut down on transactional costs can be challenging.
- Political and economic events. Political and economic events can influence the strength of a currency, attracting more or less attention from traders. They can also cause temporary volatility on the market, which can drive up the spread even higher.
Sometimes, brokers can also decrease their spreads as a promo offer to encourage traders to be more active on the market. When this happens, you have a chance to take advantage of low spreads without worrying about high volatility or liquidity.
For example, FBS has announced a period of new reduced spreads for all financial instruments, including a 10% spread reduction for EURUSD, a 25% reduction for USDJPY, and an almost 60% reduction for USDCAD. We recommend making the most of this offer while you still can.
A spread is the money a broker charges you for the services it provides. Spreads can be fixed or floating, and both types could be used to your advantage. If your broker charges a floating spread, you can wait until the market enters a period of high liquidity and take advantage of a lower spread.
If you’re looking for a broker with better spreads, FBS has several offers that might interest you, from a standard account with a floating 5-point spread and ending with zero spread accounts, depending on your preference. And don’t forget to check out our special (and limited!) promo offer and take advantage of reduced spreads.