Spread is a range between the price at which a security or currency is sold and the price at which it is bought at the same time. These are different numbers, since buyers want to buy at a lower price, and sellers want to sell as high as possible.
As forex currency pairs are traded with no commission, forex brokers implement spread as one of the ways to earn money. They include a spread into the total value of placing a trade. That means that the size of a spread indicates the cost of an exchange transaction. The size of a spread is measured in pips.
Spread also reflects the liquidity of a currency. The bigger is the gap between currency’s buy and sell prices, the lower is its liquidity. In practice this situation means it will be very difficult for a trader to sell the position quickly and profitably.
Fixed and Floating Spreads
Spreads can be different: fixed and floating. The floating spread is not static, its value is constantly in motion and depends on the dynamic processes of the market. It is very close to the real conditions that prevail in the interbank market.
Fixed spread has a constant value, and it will be the same, no matter what processes occur in the market. Usually forex brokers offer fixed spreads for micro accounts that are serviced automatically.
Factors That Affect the Value of the Spread
There are five essential forces that can affect the value of the spread.
- The liquidity of a trading instrument. This is the most important indicator. The greater is the number of market participants providing trading operations with the currency pair, the closer are the best bid and ask prices. Major currency pairs have small spreads of 0-5 pips, for example, EUR/USD. Minor currency pairs’ average spread is 5-10 pips, for example, GBP/NZD. Exotic currency pairs have a spread over 10 pips.
- The cost of the transaction. Small or too large-scale transaction volumes entail additional brokerage costs, which leads to an increase of the spread.
- Situation on the market. Political and economic events can radically affect the situation on the stock exchange. In anticipation of the financial news, the spread is growing.
- Trading hours. The spread depends on what time it is, or rather, on the time of day. When the trading session, in which the major operations with the trading instrument take place, is open, the spread is lower than at the time when the session is closed. This can be observed on major currency pairs during the night hours when the European trading session is closed and quotations occur in the Asian one. Moreover, the spread widens on the eve of weekends and holidays as brokers and traders have a rest.
- Brokerage interest. Spread is a kind of commission. Popular brokerage companies can set spreads at a low level. Conversely, little-known companies try to compensate their small number of clients with high spreads.