The first step in becoming a forex trader is to know the specific jargon that is not accessible to everyone. The notion of forex spreads should not remain an unknown term if you want to trade different currency pairs or simply intend to make an investment in the stock exchange.
What is the spread – definition
In financial markets, the spread is the difference between the purchase price and the sale price. In other words, this is the contrast between supply and demand. The spread is measured in pips or points.
Why this difference in the financial markets? Well, because it actually provides the broker’s remuneration. The spread is what the broker holds to place orders on the market. Its level varies from one broker to another, depending on the market’s volatility and the volumes traded. The most traded currency pair is the euro-dollar (EUR/USD), which is characterized by the lowest spread.
The spread depends on the underlying asset. The more active an asset is, the more liquid its market is, and the more traders there will be, the lower the spreads. In less liquid markets, such as the natural gas market, brokerage fees will, therefore, be higher.
It is essential for beginners to understand that spreads vary widely depending on market conditions. For example, during macroeconomic announcements, they are much higher, and, moreover, they are not guaranteed by most brokers in periods of high volatility. If, for example, you intend to trade during the period when the European Central Bank or the EDF is about to make an announcement, you don’t have to rely on the assumption that the fees will be the same as they are usually applied.
Factors influencing diffusion
When investing in assets such as stocks, currency pairs, or commodities, the spread is determined by other coordinates that enter the market. The purchase price (also known as Ask) is the lowest price you can buy. The sale price (which is also called the offer price) is the highest price you can sell. However, when trading derivative products, the broker often establishes its own spread, which is higher than the underlying price. This difference is, as mentioned above, the commission charged by the intermediary so that the investor can intervene on the market.
In addition to the price, there are other factors that can influence the spread:
Liquidity – in general, the more “players” (buyers or sellers) are on the market, the lower the spreads. The lower the number of players in the market, the more the spread tends to increase.
Volatility – believed to be present during major macroeconomic events (for example, the market may become volatile before an economic announcement or press release from major financial institutions). These events can cause significant variations, both increasing and decreasing, attracting risk and uncertainty. For this reason, spreads are higher during volatility periods.
Time of day – this factor is closely related to liquidity. If you trade outside the main trading hours, both the spreads and the risks will be higher.
Types of diffusion
There are two kinds of spread: fixed spread and variable spread. To choose between fixed and variable spreads, it is necessary to consider both the trading style and the way in which each trader implements his own money management strategy. To get an overview of the two types of spreads below, you will find a brief overview of the characteristics, advantages, and disadvantages of both fixed and variable spreads.
Main advantages and disadvantages of fixed spreads
The advantage of fixed spreads is that the investor always knows how much spread he has to pay for an order. Throughout the day, it will invariably be on any type of market.
Another advantage is that this type of forex spread offers stability.
However, during volatility periods or low volume periods, brokers should not maintain fixed spreads. Furthermore, the main disadvantage of fixed spreads is that they are greater than variable ones.
The foremost advantages and disadvantages of variable spreads
Unlike fixed spreads, variable variables fluctuate continuously over a day, depending on market conditions—the greater the instability, the greater the spread.
In the case of an important economic announcement, the spreads will increase intensely, in some cases, even 4-5 times more than usual.
In a context with favorable market conditions, the variable spreads will, in most cases, be lower than the fixed ones.
The importance of low spread for forex traders
The spread, therefore, influences the investor’s trading strategy and its ability to generate profits on the financial markets. Many traders aim to multiply their small gains by scalping or day trading (short-term trading styles) so that, in the absence of low spreads, it is difficult for them to make profits for a long time.
When choosing the broker you want to trade with, it is important to analyze the spreads it offers. The lower they are, the better it will be for an investor. However, one should not lose sight of the fact that operating with a low spread on the market will not determine the success of a trader in the forex market. The main aspect that must be considered when choosing a forex broker is its regulation, which guarantees the funds, as well as the reliability of the proposed platforms or customer support.