The Definitive Guide to Forex Bid-Ask Spread: From Basics to Pro-Level Analysis
All Forex traders are faced with a hidden cost that cuts into their profits on the very first trade they make. A commission or fee is not what the effect on profits is not shown on your trading report. It is the bid ask spread effect and it is built into every trade you enter into in the Forex product, or currency.
Let me ask you a question that, if you are like most traders, may sound or feel familiar: Why, after I make some trades that appear to be profitable on my chart, do I immediately lose a small amount of money the moment I hit the "buy" button
You may not consider or even fully understand it, but it predominantly comes down to spreads. Consider this hypothetical scenario: when you click on "buy" EUR/USD at 1.1000, do you know what you actually pay? It is possible you actually paid 1.1002. So you will not show a profit until the price trades above 1.1002.
What is Bid-Ask spread
The bid-ask spread is simply a distance between two prices, and is relevant across any financial market. Some refer to it as the ask-bid spread, although convention is to have the bid first and there is reason for that choice.
The bid price is the price at which buyers are willing to acquire a currency pair, with the same point in time. It is what you will get (the price you will receive) when you sell. It is the market's perspective on the "buying price."
Where it gets interesting is with different types of accounts. An ECN (Electronic Communication Network) account might show EUR/USD with a spread of just 0.2 pips, making your same trade substantially cheaper. The trade-off is that ECN accounts usually charge a different commission for each trade.
Fixed Spreads means they remain constant no matter what the market condition is. If your broker quotes 2 pips on EUR/USD Fixed Spread, you will have a cost of 2 pips regardless of whether the market is steady or has still may be working through major volatility. Being able to predict your cost certainly appeals to traders and anyone who wants to know their trading costs.
The Quantitative Effect of Spreads on Trading Expenses
The difference is compounded over time. The scalper is already costing $18,000 annually in spread cost alone, and the swing trader $1,800; therefore, both must generate very large returns to cover the cost of their strategies before generating true profit.
Position size magnifies these effects. For example, if a scalper traded 5 standard lots instead of 1 standard lot, the total cost would increase proportionately. Now, the scalper is incurring $90,000 in spread cost over 5 lots for the year.
Factors Affecting Spreads
Major currency pairs such as the EUR/USD, GBP/USD, and USD/JPY have huge trading volumes each day, resulting in very deep liquidity pools. Thus, there is no shortage of buyers or sellers, and this keeps the spreads tight (usually at or below one pip during trading hours).
Exotic pairs like USD/TRY, and EUR/ZAR often trade with much lower volumes, which means they have a wider spread of 10-50 pips or more. The lack of continuous buyers and sellers allows market makers to charge higher spreads to account for the risk of holding these positions in which they took in a defined amount of capital to purchase the market as an asset.
Spreads in Relation to Other Trading Costs
Commissions are direct fees that are billed for each trade or lot traded. ECN brokers charge between $2-7 per standard lot in commission and offer extremely tight spreads. Market makers normally create their profit margin in the wide spreads instead of charging a commission.
The combined spread plus commission structure generally provides a much better price for high-frequency traders. For example, a 0.2 pip spread plus $3 commission may in total provide the same cost as paying a 2 pip spread with no commission, especially when you consider larger position sizes.
Conclusion
The bid-ask spread is the most basic cost associated with forex trading; however, too many traders have under-appreciated the effect this cost has on long-term profitability. Even though the bid-ask spread is a small difference in price between buying and selling, that difference can actually determine success or failure with active trading.
Being aware of spreads is beyond simply knowing what the spreads are. It is about being aware of the interplay of market conditions, broker models, and an individual’s trading style in terms of what the actual cost is for you to trade. Take a day trader who places 100 trades in a month, and a position trader who places 5 trades in a month. Even if both traders employ the use of similar trading strategies, the spreads will be vastly different for both traders.
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