Forex brokers truth: Forex Spreads

Forex is an over the counter unregulated market. This means that there is no central agency like that in the futures markets that can function as a clearing house. This unregulated nature of the forex market means that most brokers are free to quote currency rates of their own. What many brokers do is add 1-2 pips to the interbank rate that they get. In times of volatility, you will find that the spreads might suddenly widen. Almost all brokers now tell their clients that no commission will be charged like that in the stock trading. What they don’t tell you is that commission is being charged in the hidden shape of spreads. 2-3 pips bid/ask spread is your trading cost and the broker’s profit.

What makes matters somewhat difficult for the average trader to understand is the fact that there are several different factors that go into the spread. Not only that, there are several different types of spreads utilized in Forex Trading. Fixed, fixed with extension, and variable spreads can all be utilized to invest. This means that if there is a fluctuation in the numbers, and it reaches the bare minimum of fees for the broker, you will not get any money. In some instances a loss will be posted, even though the fee will get paid for the process of trading. This can definitely be infuriating, especially when dealing with a variety of issues that may be beyond control of the trader. It's with this in mind that it's important to understand each component of trades made.

This should be easy. Only an inexperienced trader takes the first recommended broker. Others do lots of comparisons before settling with a choice. One of the comparison criteria is brokers’ spreads for different currency pairs. If, for example, I know that my strategy requires trading USD/JPY and GBP/JPY, I’ll go and check all available spread options with different brokers and will be looking to pick the lowest spreads for the currencies of my choice. Same selective tactics apply when shopping for leverage, margin, lot sizes etc.

Novice traders often don’t have preferred pairs as they also don’t have finished and polished trading strategies, therefore they are fine with a broker who offers more or less low spreads on common pairs, like EUR/USD, for example.

For a Forex broker it is easy to lure in such traders. Some brokers would offer competitive low spreads for common currency pairs, like EUR/USD, GBP/USD, which traders tend to compare most, but for other pairs set higher than average spreads. Novice traders buy it, and brokers stay happy. Later traders realize they want to trade other pairs as well…

Another way for Forex brokers to attract a client is to advertise about lower spreads. A broker would say that their spreads are “as low as 0.7 pips”.

There comes another wave of “they think they are smart” traders, who are glad to take such a bargain. What traders don’t realise while comparing the spreads it that those spreads are variable. Unless you are trading with true ECN broker, variable spreads could be quite costly. The problem with variable spreads that traders always complain about is: you seem to never get a spread you’ve been lured by in the advertisement. Variable spreads will vary depending on the market volatility and liquidity. Higher volatility — higher spread, lower volatility — lower spread. At the same time: higher liquidity - lower spreads, lowers liquidity - higher spreads. Could be difficult for a beginner trader to get a grasp on it at first, I know.

Opposite to variable spreads are fixed spreads: fixed spreads are easier to trade with, they don’t vary no matter what. (*Fixed may increase during news announcements. If that’s the case, a broker will warn about it).

Additionally, variable spreads go wild during news time. Biggest suckers (sorry…) come to trade with variable spreads during news releases. Ever seen a spread 40 pips wide? Yes, that’s what you may pay one day for opening a position during news time if you trade with variable spreads. (*At times fixed spreads may surprise in the same way. Be warned.)

If you go with a broker whose spreads are variable, you’re signing a contract to take “whatever is offered to you” at the moment of opening a position… This “whatever” can be very different from what’s been advertised. On the top of that you’re signing in for an additional headache of looking at spreads EVERY TIME you open a new position.

Although the spread cost itself seem to be quite a small fee comparing to the profits one plans to make, spreads add up very quickly, so quickly that for many intra-day traders it may become a determinant of profitable or unprofitable trading performance. Try to calculate how much you’ll pay in the spread cost each month.

But don’t run so happily now towards fixed spreads… Fixed spreads, you won’t believe it… can also widen. This warning is written on every broker website where you have fixed spreads. Every serious shakeout in the market: news, economic shifts other global events will immediately cause fixed spreads to expand, unless a broker promises to never widen a spread. It is your duty to check the spread before you enter with it.

ECN brokers provide the lowest variable spreads, which is the best deal, yet there is a commission cost to be paid on top. STP brokers can also offer variable spreads, but you have to monitor the spreads closer than ever. Market makers can offer variable spreads - here you have to be very cautions and look at spreads before you jump in each trade. Fixed spreads are common among Market makers and STP brokers, who get quotes from larger market makers: fixed spreads are usually wider than variable, but in the long run may actually be equal in the cost as they remain stable most of the time.