Spreads are the true cost of trading forex. Opening a position results in an immediate loss. Profits only occur whenever the price moves beyond the gap, known as the spread, between the buy and sell prices.
Bid and Ask
The screen shows two prices, the bid and ask. Novice traders understand these terms more intuitively by thinking of them as the “sell” and “buy” prices, respectively.
You can think of electronic forex trading as a form of sohpisticated haggling. Everyone may agree but that the price is generally X, but everyone also wants to try to shave a few pips off of the price. Traders want a discount.
Disagreement in the marketplace causes the bid and ask to exist. If someone wants to buy euros, someone else wants to sell them and they both agree on a price, a trade occurs. When a trade does not occur, which is most of the time, the spread reflects disagreement among the group.
A trade entering the market generally causes the price to move. Consider an example where someone buys dollars. The dollar should rise in value to reflect the latest transaction. The buy trade removes the previous ask from the market depth. The next ask becomes the best available price for purchase.
The other side of the market, the bid, sees the price adjust. Traders typically responds by adjusting the bid in the same direction. The traders offering the bid expect the price to rise. That is, after all, the reason that you’re able to sell. You’re selling what they’re buying and you’re buying what they’re selling.
The movement of the price causes a reaction. The people behind the bid still want to buy at a price better than the market using a limit order. They also realize that the price is moving away from them. A common reaction is for the bid to adjust approximately the same distance as the movement in the ask. The adjustment in the spread is what keeps it relatively consistent.
Spread mark up
You only pay the spread once. When you enter a buy trade, you enter on the ask. The only way to exit that trade is by selling at the bid, a problem that occurs immediately upon entry. The movement of the ask price from that point forward is completely irrelevant. The ask could drop or explode upwards. It doesn’t matter to your trade. Your trade can only exit on the bid. It’s the only price that counts when you’re already long.
One unique aspect of forex trading is that the brokers bury their commissions in the spread. Say, for example, that the wholesale price of USDJPY is 76.480 on the bid and 76.485 on the ask. Brokers read this type of quote 76.480 at 76.485, with the bid coming first and the ask quoted last.
The broker then takes the prices and mark them up like any middle man. The mark up varies between brokers. Most charge an additional 1 to 2 pips per transaction.
The broker faces three options when marking up the spread – he can add it to the bid, the ask or he can split the difference between the two. Current market conditions dictate which option is the most suitable.
Although it seems like a good idea to tack half of the mark up on both sides of the bid ask spread to eliminate guessing incorrectly, this doesn’t usually work out well for the broker. Order flow comes in very unevenly and usually with a strong bias in one direction.
I posted in the past about forex trader sentiment and how lopsided the trades of retail traders can be. If the forex broker sees that 75% of the GBPUSD orders coming in are to buy, then it makes sense to heavily weight the spread cost to where all of the business is.
Consider an example where the next 100 lots traded will be 75% buys and 25% sells with a 1 pip markup. If the 1 pip mark up on the spread applies to only the bid, then there would only be 25 lots where the broker earns his pip. That’s the dumbest thing he can do in that situation. He could evenly split the markup with 0.5 pips added to the bid and 0.5 pips added to the ask. He would make 0.5 pips on 25 lots and 0.5 pips on 75 lots for a total of 50 pips. The best scenario for the broker is to let the traders going short trade for free and to charge all of the traders going long the full pip. He doesn’t make anything on the short flow, but he makes 75 pips on the long traders. It’s clearly in his best interest to full mark up the spread in one direction whenever the order flow is uneven.
Traders are on the losing end of spread markups. It completely eliminates pricing transparnecy. Most brokerages allow you to review within their statements the break down of profit and loss into categories. Commissions and trading costs are most definitely found on every trading statement from stocks and futures brokers. Not so in forex. You can guess trading costs and that’s it.
Spread mark ups also eliminates trading opportunities. A client that I visited in Dubai in 2009 absolutely loved FAP Turbo. He swore up and down that it was the greatest EA that he ever bought. His only complaint was that the EA’s performance depended entirely on the broker. He often complained the most about FXCM because they charged the largest mark ups.
FAP Turbo worked by waiting for unlikely, fleeting moments of volatility in ranging pairs like the EURGBP. When the price corrected, the EA sought to take the smallest of profits – something on the order of 3-5 pips. The problem stemmed from the fact that the mark up would cause the take profit not to hit. The wholesale price would reach the limit, but because of the spread mark up, the price he was paying often missed his limit. My client preferred to pay a direct commission. Even though the cost was identical, the increased probability of a successful trade dramatically affected the net outcomes.
Spread reflects risk and liquidity
Each currency pair usually has its own spread. The spread of a currency is a function of its risk and liquidity. When traders look at an exotic currency pair like the ZAR/JPY or USD/TKY, the first thing that they notice are the spreads that seem incredibly wide when compared to the pairs that they’re used to trading. That’s because hardly anyone trades those pairs.
The lack of interest means that anyone that makes a market in an FX pair needs to receive sufficient compensation to make it worth their while. Sufficient compensation here means charging you a fat spread. The low trading volume, which is called liquidity, creates a problem with risk. The largest financial instruments in the world like currencies and stock indeces usually only move a few tenths of a percent per day. Instruments with less trading activity almost always exhibit higher volatility. Prices are more suspeptible to violent moves when fewer people participate in a market. The people making a market in those currencies charge a higher premium as a consequence.
Trading is a marketplace
It’s important to remember that the numbers on the screen are not computer generated. They are real prices that real traders offer in the market place.
The word trade accurately describes the transaction. Someone must agree to a trade before it can occur. Clicking a button to buy does not assure that you get to buy an unlimited quantity at the price displayed.