Did you know that spreads are not equal in forex? As traders, brokers offer either variable or fixed spreads. While both are fairly reasonable, each can impact traders differently based on a plethora of dynamics that this article will explore.
Trading is a business, and like any business, there are expenses involved which traders cannot gloss over.
The spread is the one consistent cost encountered in every position. We can think of this as a broker’s mark-up because there is always a small fee for every currency pair they have bought or sold from the interbank market.
More technically, the difference between the exchange price a broker sells and buys a forex pair is the spread. Before a trader initiates an order through a trading platform, they will see the bid (buying) and ask (selling) prices for the market in question.
For example, if the EUR/USD quotes was 1.19500/1.19550, the spread is 50 pips. If one opened a buy trade here, their order would execute 50 pips above 1.9500. If it were a short position, the entry price would be 50 pips below 1.19550.
In forex, these spreads can either be variable (also alternatively referred to as floating) or fixed.
Variable and fixed spreads
A variable spread changes or varies according to present market conditions. Conversely, a fixed spread commonly remains unchanged regardless of the volatility and liquidity depth.
Here, a trader will pay a set commission that varies according to the pair, making costs more predictable. Excluding this fee, these spreads are cheaper if accounting on a trade-by-trade basis. They are vital for trading exotic markets that naturally incur sometimes unusually high costs.
Nonetheless, variable spreads do also remain pretty consistent throughout most trading sessions. They tend to fluctuate when there is an overlap, high-impact news events, and during periods of low liquidity (such as during the rollover starting on a new trading day).
How the brokerage models typically affect the spread
Brokers in forex are generally classed as either STP (straight-through processing) or dealing desk. The former sends a trader’s orders ‘straight through’ to liquidity providers with no intervention.
With the latter, the positions are instead dealt with internally by the broker. There is a perception STP brokers tend to use variable spreads that accurately reflect actual market dynamics.
On the other hand, dealing desk brokers tend to employ fixed spreads because for this to happen, they essentially create somewhat of a synthetic market mirroring the real one (hence sometimes being referred to as market makers).
This brokerage model continuously receives a lot of backlash and controversy in trading communities due to the perceived conflict of interest. In truth, retail traders can never truly know which system a broker uses.
It is more probable nowadays brokers fall into both rather than exclusively one, and most dealing desks are ethical and do not engage in manipulation tactics as many would believe.
So, is there a clearly-defined superiority between variable and fixed spreads?
Which traders should consider fixed spreads?
It’s crucial to note that although fixed spreads provide the advantage of predictable costing (unlike variable spreads that can change on the fly), this doesn’t necessarily mean they are cheaper in the long-term.
We should not forget there is also a set commission per trade, which can vary widely. So, we can conclude fixed spreads are inexpensive on an individual position, but the commission could make the overall costs higher.
Also, such spreads never truly remain ‘fixed’ as there are rare occasions where they will widen as variable ones do. Overall, they do stay consistent in the majority of circumstances.
Nonetheless, scalpers, day traders, traders who use tighter stop losses, and those utilizing expert advisors or robots should consider this cost model to ensure more reliable costing even during busier periods.
As many guys in this group rely on frequent trading, transaction costs have a notable influence on their bottom line. A mere five pip spread change may seem small, though it does make a difference in the long run.
Since many of these traders deal with small profits using tighter-stop entries, the spread needs to be as low as possible.
The one slight edge of fixed costs benefitting all traders is the impact of widening spreads.
Let’s illustrate with an example; a trader enters a trade into Broker XYZ’s platform where the spread (floating) of EUR/USD is ten pips. This position goes into profit 50 pips, where they now decide to move their stop loss to breakeven.
At 8 p.m., there is a high-impact news event that, for just 30 seconds, widens the spread to 60 pips, kicking them out with a slight loss of -10 pips (50-60). If the trader took the same position with identical parameters on a broker with fixed spreads, it is likely the widening may have only been 30 pips, which would have kept them in the position.
While such high-volatility occasions are rare, though, for some, they are essential considerations as when the price jumps erratically after ‘accidentally’ closing someone’s position, it makes it unfavorable to re-enter the trade (which may have eventually become a winner).
Which traders should consider variable spreads?
This now leaves us with the opposite camp of speculators, swing, and position traders. Because this group naturally trades less frequently, spreads don’t matter as much, mainly as they use wider stops and bigger profit targets.
So, even if one pays a 15 pip spread, it has no bearing if their profit potential is 200 pips. By using wider stops, even when markets experience some high volatility, they have a ‘buffer’ enabling them to stay in positions for longer.
There isn’t a clear winner between fixed and variable spreads because each has its own advantages and disadvantages. However, perhaps the fixed system is slightly better because, during rare periods of spread widening, the impact is not as severe compared to the variable type.
The one superior benefit with the latter is it’s generally over time cheaper since there generally shouldn’t be any commission.
Nonetheless, most forex brokers are on the cheap side when it comes to transaction costs due to the fierce competition. So, rarely will a trader have to deal with unnecessarily high spreads on many occasions, though as we’ve seen, this can happen infrequently.
The impact of the latter events may be severe or minor, depending on the cost type. Another consideration is the trading style. Short-term traders and those using robots (to where transaction costs are a major factor) should consider fixed spreads.
Fees are mostly insignificant for those trading long-term (swing and position trading) primarily due to the low trade frequency and wider stop loss size.