Forex trading has immensely increased in popularity in recent years, with lots of novice traders entering forex market daily with the hope of making some money. However, for newbie traders, forex trading can be challenging at first as there’s a lot to learn and big decisions to make.
Since there is no central marketplace for forex trading, traders who want to trade currencies have to find a brokerage company which will connect them to the interbank system via a trading platform. Typically a FX broker will offer you the best price available of a currency pair from banks that have access to forex liquidity. But how does the broker benefit from all this? Well, there are several sources of income for forex brokers but their primary source of income is spread.
What is Spread ?
Spread can be defined as a commission charged by a Forex brokers on their traders for trading on their platform. It can also be defined is the difference between the bid and ask price for a currency pair. It’s usually denoted in pips.
To fully understand what bid and ask prices are in FOREX market, you need to first know that in the forex market, prices are usually represented as exchange rate quotations or currency pairs. Usually, when a trader opens a trade, the broker will pass it through to the market. In order to do this, the broker will offer a price for the particular currency pair that is slightly more than the market price. For example, they can quote it as EUR/USD 1.3601/1.3607, where the first figure is what the forex broker will give its clients if they want to sell that pair. This is what is is referred to as BID price. and the second figure represents the price at which the FX broker will charge for buying the currency pair, which is known as ASK price. As you can see, there is a difference of 0.0006 or 6 pips between the bid and ask price, which is now the broker’s commission, also referred to as spread.
Spreads may narrow or widen depending on market volatility. This means that if market is volatile, your spread may change for every order you place within that period. The amount of spread a broker charges can significantly affect your profits which is why traders are advised to work with brokers with low spreads.
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Type of Spreads: Floating and Fixed Spreads
When choosing a broker, one of the first things you should consider is the type of spread they are offering. In the Forex industry, there has been always an on-going debate about which type of spread is the best for trading. When trading forex, there are two main types of spreads you’ll encounter – floating spreads and fixed spreads. Some forex traders prefer the former due to some reasons while others prefer fixed spreads due to certain reasons. In this article, we shall be looking at the benefits of fixed spreads and how traders can use it for their own benefits. But first of all, we shall first point out the differences between the two main types of spreads.
Also known as variable spreads, these are spreads that will fluctuate depending on market conditions. Variable spreads don’t remain static at any given time but change depending on market volatility. This means that they be high at sometimes and low at other times.
Typically, when the market is very busy, the broker will charge lower spreads than when the market is slow. Therefore, if you want low spreads, you should trade during the London and New York session, but if you want high spreads, you should trade during public holidays, or during the Sydney and Asian session. During economic news reports, floating spreads can widen as much five times the normal spreads offered during normal market conditions, which can very dangerous. This, however, depends on the broker’s transparency as some ECN brokers will charge very small floating spreads even during economic news releases times.
Most true ECN brokers offer reasonable variable spread as they operate with a non-dealing desk. Their spreads don’t widen much even during news release times although they may charge an extra commission. True ECN forex brokers that offer variable spreads usually give you direct access into the FX market. While the variable spreads can make your trading somehow unpredictable, it allows you to deal with the real prevailing market prices.
Fixed spreads refer to spreads that remain static for a currency pair irregardless of the market conditions. This means that the bid and ask price of a currency will remain constant no matter what’s going on on the market. For example, if a forex broker is offering a low, fixed spread of I pip on the EUR/USD pair, this implies that even if the market becomes volatile, you can still place an order on that pair and pay only 1 pip.
You’ll find that many brokers that are offering fixed spreads will charge a different spread for each pair. However, there are some that charge fixed spread for all their major currency pairs. This spread will remain constant even during public holidays, bank holidays, economic news release announcements, or during sessions when market volatility is low.
Fixed spreads allow you to know the currency transaction cost beforehand. This helps you develop your strategy and estimate your profits even before you place your trades.
However, fixed spreads can be difficult to work with sometimes because they are usually wider. This is not an excuse for professional traders but to novice ones, it can be very risky. Most brokers that have fixed spreads are usually Market Makers and they usually operate with a dealing desk.
Benefits of Working With Fixed Spread Brokers
We have seen that fixed spreads are usually set by the forex broker and remain constant regardless of the market volatility or conditions. The spread that the broker is is offering is the one you will pay at all the times.
Although variable spread at 0.1 pip on a currency pair may look more attractive, fixed spreads can save you a lot of money throughout the course of your forex trading.
Below are the top 6 benefits of fixed spreads in the forex industry;
1. More transparency
Transparency means a lot in the forex industry. You want to know exactly what you’ll get from your trades so that you develop your strategy. Fixed spread brokers offer more transparency than floating spread brokers when it comes to the currency transaction costs. With this kind of broker, you will know exactly what you are going to pay for every time you place your trade, regardless of market volatility, interbank liquidity, trading volumes or time of day. When a broker offers fixed spreads, it means that the price will remain constant leaving no chance for them to manipulate the prices in their favor. So, as a trader, you’ll know exactly how much you’ll make from your trades.
2. Lower costs
By choosing fixed spread brokers, you can significantly reduce your trading costs. Unlike variable spreads, fixed spreads don’t offer any surprises, which means that, as a trader, you can plan and budget for the costs of your trade transactions well in advance. This way, you will be able to manage your costs throughout the course of your career in trading.
3. Easier news trading.
The forex market is highly volatile which is caused by various factors like economic news release events. While floating spreads may be quite beneficial during quiet market conditions, fixed spreads are highly recommended for volatile market conditions. Floating spreads can rise as high as 12 pips during such volatile periods which can dangerous.
4. Safeguard against volatility
As mentioned above, floating spreads can be very dangerous during volatile market conditions. When the market is volatile, trading with variable spreads can be very difficult because of how wide the buy and sell prices fluctuate. However, by choosing fixed spreads, traders may protect themselves from such slippages.
5. Effective Short-term strategies
Short-term FX trading strategies usually involve making numerous trades within a short period of time. This can be quite easier and more predictable when using fixed spreads. Since the potential gains from these strategies can be small, using fixed spreads will ensure a higher level of cost transparency.
6. Peace of Mind
All of the above benefits offered by fixed spreads give you peace of mind as you don’t need to worry about volatile periods of the market. With fixed spreads, the bid and ask price will remain constant no matter the market condition this will make you place your trades with peace of mind.
These are some of the benefits of fixed spreads. While these spreads may be a bit wider under normal market conditions, they could work in your favor if you are trading in volatile market conditions like during economic news release times or data releases. If you are new to FX trading, you will also find that fixed spreads provide a better and more predictable forex trading environment which helps you reduce risks as you become acquainted with the intricacies of forex trading. If you decide to use fixed trades, ensure you work with a reputable and licensed forex broker.