What is a spread?
When considering Forex trading, it is important to understand what a foreign exchange spread is. A spread is the difference between the ask (buy) price and the bid (sell) price. The spread is always quoted in the pips. A pip is the smallest unit of difference between the two currencies in the quote. For example, if the quote between USD/EUR is 1.2222/4, then the spread equals 2 pips, the difference between the 2 and the 4. If the quote is 1.22225/4, then the spread is 1.5 pips.
The spread is how Forex brokers make their money. Wide spreads result in a higher asking price and a lower bid price so you end up paying more when you buy and receive less when you sell, often making it difficult to realize a profit. That is the reason brokers try to offer the trader the ‘tightest’ spread they can. The spread is part of the compensation paid to the brokerage for the risk it undertakes when a trader places a trade.
Spreads can cut into your profitability over the long-term. If using a trading strategy that aims for large gains, spreads may not have much of an effect. But if you are a scalper and you reach for 5-10 pips at a time, paying a 4 pip spread won’t be very profitable.
There are several types of spreads.
With the Fixed Spread a trader knows exactly what the spread will be before entering a trade and the number never fluctuates. Some Forex brokers publish a list of spreads and you can see exactly how many pips the EUR/USD pair is costing, say 3 pips. If it turns out that the cost to the broker is more than that, the broker ends up losing the difference.
Many brokers offer the trader a variable spread instead of a fixed spread. A variable spread, fluctuates depending on market conditions. When market liquidity is positive, the spread can be low. But when market conditions are not so good, a variable spread will cost you more than a fixed one.
Fractional Spreads are used regardless of whether you have a fixed spread or a variable one. A fractional spread is used by a broker that calculates the quote with five decimal places, which gives a more exact quote.
When you are trading in the Forex market, the spread can impact your profitability. If you are using a Forex software program, it might only accept trades when the spread is below a certain point. If this is the case, you may not get many trades when the spread is high.
Since spreads vary with each broker, it is worth your while to shop around until you find the broker that offers you the best spread. Before opening an account with any broker, a good idea would be to try out a demo account so you can test the waters and gains some experience in the process. When you feel more confident, you can transfer over to a real account with the same or a different broker.
You man also try changing the times of day you place your trades. By trading at more liquid times, you might get better spreads.