What is the spread mechanism in forex

Spread or Spread is one of the established terms in financial dictionaries as it is used to refer to the difference between the buying and selling prices of currency pairs. Almost all forex traders make sure to look for a broker that offers the lowest spreads before opening a trading account. Even inexperienced traders know very well that low spreads make it easier for them to enter and exit trades at the lowest possible cost. Also, scalpers looking to make a profit of between 3 and 5 pips on each trade relentlessly look for brokerage firms that offer the lowest possible spreads as a large part of the cost of trading. However, there are many things to consider when determining entry and exit levels as the decision is not limited to just the spread. Now let’s go through the impact of the spread on forex trading in detail.

 

Points

Before delving into how the spread works, it is necessary to understand the meaning of a pip or pip in forex rates. You probably already know that a pip is the smallest possible change in a currency pair’s exchange rate movement. For currency pairs quoted to four decimal places, the last decimal place is the lowest possible change. In this case, the pip or pip is equal to 1/10,000 of the price unit. So 1 pip equals 0.0001 for currency pairs with quotes to four decimal places. For pairs where the Japanese Yen is the quote currency and quoted to two decimal places, one pip equals 0.01.

 

Most retail forex brokers currently offer rates with five decimal places. The fifth decimal place is called the pipette, which is 1/10th of a whistle. Thus, a 10 pips increase or decrease results in a 1 pip change in the exchange rate. When these fractional pips are used with JPY pairs, quotes are made up of three decimal places.

 

Ask and offer prices

Banks act as premier liquidity providers in the forex markets as they compete with each other to offer the best bid and ask (buy and sell) rates. Prime brokers pass the quote, also known as the real price, to the forex broker serving retail clients. This broker subtracts a point or two from the bid price and adds a point or two to the ask price so that it can manage its operating expenses and make profits from its activity. For example, let’s say the brokerage firm receives the bid and ask prices for EUR/USD at 1.2420 and 1.2421. If the forex broker intends to add a spread of up to 2 pips to even out its operating costs, the final bid and ask prices that the client will receive are 1.2419 and 1.2422. In this case, the client can only sell the euro at 1.2419. But he can also buy the euro at 1.2422. These agreements ensure that the brokerage firm receives fair consideration for the services it provides to its clients. Depending on the risk management policy applied by the broker, the trade order may be routed directly to liquidity providers or bundled with other orders and then hedged against this bundled order at Tier 1 brokers.

 

Here is an example of a variable spread between bid/ask prices, taken from the MetaTrader 5 platform:

 

The EURUSD chart shows how spreads change over time

Determine the point value

The value of each pip depends on the currency pair being traded, the lot size and the exchange rate. Let’s take an example to understand how pip value is calculated. Let’s say a trader opens a BUY position of 200,000 EUR (2 standard lots) on EUR/USD at 1.2440. Also, let’s imagine that the trader closed his position at 1.2460, i.e. he made a profit of 20 pips.

 

In this case, we can calculate the pip value of the trade as follows:

 

To buy the EUR/USD pair at 1.2440, the trader must pay $248,800 (1.2440 x 200,000) for 200,000 euros.

 

The lowest possible price movement is 0.0001 (1 basis point).

 

The Eurodollar deal closing price is 1.2460 so the pip value in Euro can be calculated as follows:

 

Point value = 1 point / exchange rate x transaction size

 

0.0001 / 1.2460 x 200,000 = $16.05

 

In this case, the dollar value of the point is 16.05 x 1.2460 = $20.

 

Total profit from the trade = €16.05 x 20 pips = €321 or $400.

 

Now suppose the trader gained 23 pips instead of 20 pips in the previous example.

 

The total profit of the deal in this case is 369 EUR or $460. In other words, a difference of up to three points would have resulted in an additional profit of EUR 48 or $60. we canWe can now apply the same equation to understand the effect of spread on a forex trader’s net return.

 

In the example above, if the forex broker bids after adding a spread of 2 pips, the trader will suffer a loss due to the spread of $20 x 2 = $40, i.e. 10% of the profit made ($40 / $400 x 100%).

 

Let’s assume instead that the trader closed the position at 1.2410, which is the price of EUR/USD at the time of the close. In this case, the pip value in euros would be: 0.0001 / 1.2410 x 200,000 = 16.12 euros

 

The dollar value of the pip remains the same at $20.

 

So the total loss for the trade = 16.12 EUR x 30 pips = 483 EUR or $600.