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March 31, 2016

Question:What does spread mean in Forex market? How to calculate that?

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Answer:

Spread is the difference between Bid and Ask prices.

If you login to your trading platform, you will see the two prices for each financial instruments as below.

  • Bid price is the price when you sell the currency.
  • Ask price is the price when you buy the currency.

Market Wach

Two way prices for commissions

There is this spread for each financial instruments for brokers to make money.

The spread is simply the commissions earned by brokers, and the spread is different for each broker.

All brokers quote the prices from Interbank liquidity, the original Forex market where large amount money is traded between banks.

And brokers have the right to get involved in the trading(market) and the brokers give traders the chance to trade with the Interbank Market.

But before the brokers giving the opportunity to traders to trade Forex, they put the markups on the spread. Meaning that Brokers widen the spread so they can earn commissions by traders trading with its platforms.

Variable Spread

There are two types of spread, and one of them is the Variable spread.

Variable spread means that the spread(the difference between bid and ask prices) changes according to the market conditions.

It could get wider or tighter in any moment.

Conditions of Variable Spread
  • Normally tighter spread than the fixed spread type
  • Gets wider when there is high volatility in the market

Fixed Spread

Another type of the spread is the Fixed Spread.

In this case, the spread is always fixed, for example 2 pip or 3 pip, and it does not change most of the times.

It does not get wider or tighter.

Conditions of Fixed Spread
  • Normally the spread is wider then the variable one
  • Some restrictions upon trading
  • Able to perfectly hedge positions and does not get affected by market conditions

When you selecting your broker, you want to find the one with tighter spread just like anyone.

But there might be something you need to know before deciding your broker.

STP = Wider Spread

“STP Brokers” means that your orders will be directly sent to the real market and your orders actually affect the price of the real exchange market. (at least a little bit…)

If a broker adopt the STP model, that means that the broker will only make profit by the spread and there is no interest of conflict between traders and the broker.

As the broker only makes profit by the spread, they surely need to make money only with the spread. So the spread gets naturally wider.

Or the brokerage company will end up with bankruptcy anytime soon.

STP model brokers may offer wider spread, but there are some merits like trading with the real market and no restrictions on the trading methods etc.

OTC = Lower Spread

OTC model is where the brokers hedge your positions to make even more profits by that.

So the orders from the traders will be sent to the broker, but not the real market, and the brokers is actually just placing orders oppositely when you place orders.

If you buy 1 lot of EURUSD, the brokers sell 1 lot EURUSD, and that how the trades work.

Why the brokers hedge positions?

It is commonly known that more than 80% of traders lose their funds in trading Forex.

Well that means that if you trade oppositely, you will make profits by 80%.

So brokers came up with ideas that hedging positions of these traders will make money and there is even a certain data for that.

This will cause the conflict of interest between traders and brokers and sometimes the brokers cancel some profits of traders with some reasons.

But the OTC model brokers does offer tighter spread than the STP model brokers, because they can afford it.

Making money by the spread is not the biggest business for them, but hedging positions is.

Japanese brokers with the lowest spread in the world

This information is just for entertainment….

Brokers in which country offers the tightest spread? The answer is Japan.

Japanese brokers offer 0.3 pip fixed spread at all times to traders.

This is because their business model is complete OTC and even set highly strict trading conditions.

Also there is no NBP(Negative Balance Protection), so traders need to cover their losses.

The trading conditions may be worse than others, but the spread is the best in the world.

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