I am writing this article keeping in mind that you already know what a bid and ask price is. If you don’t have knowledge about the bid and ask, please read the article bid-ask and spread first.
So, a spread is the difference between the values of the bid and ask price which includes the service cost of the broker and transaction fee. Spread in the forex world is measured in pips.
Let us consider the currency pair of British Pound (GBP) and U.S. Dollar (USD).
Suppose GBP/USD = 1.2832
Now you plan to buy GBP at the ask price, but when you place the order, there is a high probability that you may not get it at the CMP (Current Market Price). This is because may be the ask price is a little higher, perhaps 1.2834, which is the price you may pay for.
Same thing happens with the seller. When he places the order, he may not receive at the asked price. He may get 1.2830.
The difference between the 1.2834 (bid price) and 1.2830 (ask price) is 0.0004 (Spread).
Types of Spread
There are two types of spread in which the traders can trade:
- Fixed Spread
- Floating Spread
Fixed Spread: As the name says fixed spread remains fixed and is not dependent on the general fluctuation of the market. However, there could be a temporary change in high market volatility and low liquidity, but once the market comes back to a normal condition, the spread also turns back to the general level.
Although fixed spread is considered less risky and more predictable, an increasing number of companies are adopting floating spread to offer more innovation to the clients.
Floating Spread: As the name says, a floating spread keeps on changing with market fluctuations. Many companies offer a side ECN (Electronic Communication Network) account as floating spread is entirely dependent on the market phenomenon and characterizes the interbank relationships. Using an ECN account, the traders can easily trade only with those who have this side account. Due to this, the floating spread becomes narrower. The broker takes his commission while the traders trade.
A beginner should never go for a floating spread due to its risky nature. Many brokers claim that they can make the spread narrower as compared to the fixed spread, but the floating spread has its own disadvantages. One such disadvantage is that the spread may increase up to 10 pips. Also, after placing the order, you may see that the price at which the order is finally executed is much higher.
How to Minimize the Spread?
There are two ways to reduce the spread:
- Trade at the time when there are maximum buyers and sellers. This is because, as the buyers and sellers increases, the competition for a currency pair also increases which ultimately means narrower spread.
- Always trade in highly traded currencies as multiple market makers trade for big currencies. On the flip side, traders ignore the currency which is not famous in the forex market and that is why the spread in those currencies is always wider.