Before you understand what a spread is you should first of all understand that in the foreign exchange market prices are represented as currency pairs or exchange rate quotation where the relative value of one currency unit is denominated in the units of another currency. An exchange rate, applied to a customer willing to purchase a quote currency is called BID. It is the highest price that a currency pair will be bought. And a price of quote currency selling is called ASK. It’s the lowest price that a currency pair will be offered for sale. BID is always lower than ASK. The difference between ASK and BID is called spread. It represents brokerage service costs and replaces transactions fees. Spread is traditionally denoted in pips – a percentage in point, meaning fourth decimal place in currency quotation.
Following types of spreads are used in Forex Trading
Fixed spread – difference between ASK and BID is kept constant and do not depend on market conditions. Fixed spreads are set by dealing companies for automatically traded accounts.
Fixed spread with an extension – certain part of a spread is predetermined and another part may be adjusted by a dealer according to market.
Variable spread – fluctuates in correlation with market conditions. Generally variable spread is low during times of market inactivity (approximately 1-2 pips), but during volatile market can actually widen to as much as 40-50 pips. This type of spread is closer to real market but brings higher uncertainty to trade and makes creation of effective strategy more difficult.
Observing variable spread graph trader could define moments when value of the spread reaches its extremes – either maximum or minimum. On the moment of minimal spread (between 0 to 1 pips) he or she can open simultaneously buy and sell positions and later close both of them on the moment of maximal spread. As a result profit will equal to maximal spread value. This trading strategy under variable spread conditions has an advantages of low risks involved, because profit probability does not depends in this case on actual currency pair quotation but only on spread value. More over if the trading position is open during minimal spread it guarantees breakeven result and makes profit earning highly possible.
There are several factors that influence the size of the bid-offer spread. The most important is currency liquidity. Popular currency pairs are traded with lowest spreads while rare pairs raise dozen pips spread. Next factor is amount of a deal. Middle size spot deals are executed on quotations with standard tight spreads; extreme deals – both too small and too big – are quoted with broader spreads due to risks involved.
On volatile market bid-offer spreads are wider than during quiet market conditions. Status of a customer also impact spread as large scale traders or premium clients enjoy personal discounts. Nowadays Forex market characterizes high competition and as brokers are trying to stay closer to customers, spreads tends to be fixed on lowest possible level.
Each trader should pay sufficient attention to spread management. Maximum performance can only be achieved when maximum quantity of market conditions is taken into account. Successful trading strategy is based on effective evaluation of market indicators and specific financial conditions of a deal. The best tools here are complex analysis, forecasting, risk/return analysis, transaction cost evaluation. Because spreads are subject to change, spread management strategy should also be flexible enough to adjust to market movement.
As a newcomer to the Forex market, there are several terms used that you may require a definition for. ‘Pips’ and ‘spreads’ are two of the most commonly used terms in the Forex ‘dictionary’. Both these terms are also a very important attribute of the Forex market as both represent the value of a currency pair to the trader and the broker.
In the Forex market, the value of a currency is presented in pips. A pip is a number value; the majority of currencies are priced to four numbers after the decimal point. Here is an example; a 5 pip spread for EUR/USD is 1.2345/1.3456.