Understanding Foreign Exchange Trading Spreads

Provided By Ultimate Trading Systems

You Must Find A Broker Who Offers You The Best Foreign Exchange Trading Spreads

Nothing affects your profitability more than the foreign exchange trading spreads offered by your Broker. But spreads in the foreign exchange trading spot market can be confusing to understand, and the marketing from many brokerages can be deceiving. Nearly every broker is claiming to have the tightest foreign exchange trading spreads in the industry. But what does this mean, and how can you tell if a brokerage is delivering what they promise.

In order to understand the foreign exchange trading spread, you need to know what it is. A foreign exchange trading spread is the difference between the ask price (the price you buy at) and the bid price (the price you sell at) that is quoted in the pips. The pips are the smallest unit of difference between the two currencies in the quote. If the quote between EUR/USD at a given moment is 1.2222/4, then the foreign exchange trading spread equals 2 pips, the difference between the 2 and the 4. If the quote is 1.22225/4, then the foreign exchange trading spread is going to equal 1.5 pips.

The foreign exchange trading spread is how brokers make their money. Wider foreign exchange trading spreads will result in a higher asking price and a lower bid price. The end result of this is that you will pay more when you buy and get less when you sell, making it more difficult to realize a profit. Brokers generally don’t earn the full spread, especially when they hedge client positions. The spread helps to compensate the brokerage for the risk it assumes from the time it starts a client trade to when the broker's net exposure is hedged (which could possibly be at a different price).

Foreign exchange trading spreads affect the return on your trading strategy in a big way. As a trader, your sole interest is buying low and selling high (like futures and commodities trading). Wider foreign exchange trading spreads means buying higher and having to sell lower. A half-pip lower spread doesn't necessarily sound like much, but it can easily mean the difference between a profitable trading strategy and one that isn’t.

The tighter the foreign exchange trading spread is the better things are going to be for you. But tight foreign exchange trading spreads are only meaningful when they are paired up with good execution. A good example of this is when your screen shows a tight foreign exchange trading spread, but your trade is filled a few pips in the wrong direction, or is mysteriously rejected.

When this occurs repeatedly, it means that your broker is showing tight foreign exchange trading spreads but is effectively delivering wider spreads. Rejected trades, delayed execution, slipping, and stop hunting are foreign exchange trading strategies that some brokers use to get rid of the promise of tight spreads.

Foreign exchange trading spreads should always be considered in conjunction with depth of book. Oddly enough, when it comes to economies of scale, FOREX doesn't even act like most other markets. On the inter-bank market, for example; the larger the ticket size, the larger the foreign exchange trading spread is. So when you see a 1-pip spread on an ECN platform, you have to wonder if that spread is valid for a $2M, $5M or $10M trade, which it probably isn’t. In many cases, the tight spread that is offered applies only to a capped trade sizes that don’t work for most of the common foreign exchange trading strategies.

Spread policies change a great deal from broker to broker, and the foreign exchange trading policies are often difficult to understand. This makes comparing brokers difficult. Some brokers actually offer fixed foreign exchange trading spreads that are guaranteed to remain the same regardless of market liquidity. But since fixed foreign exchange trading spreads are traditionally higher than average variable spreads, you can end up paying an insurance premium during most of the trading day so that you can get protection from short-term volatility.

Other brokers offer traders variable spreads depending on market liquidity. Foreign exchange trading spreads are tighter when there is good market liquidity but they will widen as liquidity dries up. When it comes to choosing between fixed and variable rates, the choice depends on your individual foreign exchange trading pattern. If you trade primarily on news announcements that you hear, you may be better off with fixed spreads. But only if the quality of execution is good.

Some brokers have base the foreign exchange trading spreads they offer their clients on the type of account the client has. For example; those clients that have larger accounts or those who make larger trades may receive tighter foreign exchange trading spreads, while the clients that are referred by an introducing broker might receive wider spreads in order to cover the costs of the referral. Other brokers offer the same foreign exchange trading spreads to everyone.

It is often difficult to get information on a company’s spread policy or its order book depth. Because of this, many traders get caught up in the promises they hear, often take a broker's words at face value. This can be dangerous. The only real way to find out what a company’s policy really is to try out various foreign exchange trading brokers or talk to those who have.

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