What is a Spread?
The spread is a commission deducted by the broker upon executing a position in the trading platform. A spread is often seen when trading Forex, Commodities, Stocks, Indices and CFD’s. Due to the immense competition in the financial industry brokers may offer different spreads to appeal for both seasoned and new traders.
Let’s begin with understanding the market spread in the Forex market. Inside your trading platform where you see the quotes of multiple currency pairs you see the terms ‘Bid’ and ‘Ask.’ The bid price is the selling price and the ask price is the buying price. The rates are almost identical until the fourth decimal point, which is the pip.
The Bid and Ask
We are going to take EURUSD as an example:
Bid: 1.2496 Ask: 1.2498
The difference between the bid (selling price) and ask (buying price) is the market spread for EURUSD. If you subtract the ask from the bid you will receive 0.0002, which is 2 pips. We can therefore establish the spread of Euro-Dollar in our example is two pips.
When you execute the trade in the trading platform you will begin with -2 pips. This is the commission forex brokers charge for the transaction. If you decide to buy EURUSD, you would require the price to rise by 2 pips in order to cover the spread and anything beyond is your profit. If however you choose to sell EURUSD, you would require the price to drop by 2 pips in order to breakeven and any further weakness is your profit.
When a trade is executed, the broker must also pay a spread for the transaction. However, the spread the broker pays is relatively small. In order to profit, the broker adds a certain amount of pips to the spread in order to profit, commonly known as a mark-up.
If your spread for EURUSD is two pips, rest assured the broker is probably paying less than half a pip for the transaction. This is how brokers earn their profit from the spread. A market maker is often able to provide tighter spreads as it also profits from its clients’ losses and does not solely rely on profiting from the spread.
Brokers that wish to increase their income from the spread must ensure its traders will place large positions in the market or the total size of the executed trades will be significantly high. The larger the trade, the larger the pip’s value, the larger the commission. To increase the trading volumes, trading signals may be provided from various sources by the broker as well as multiple market reviews on a daily basis.
Due to the immense competition, brokers will opt to provide the tightest spread for the most traded currency pairs in the Forex market, particularly for EURUSD and GBPUSD.
The reason why a tight spread is important as less pips would be required in order to breakeven. Scalpers and intraday traders will favour tight spreads as it is a crucial part to the trading strategy. Traders that exercise swing trading strategies will be less concerned by the spread as long it is not excessively large.
Floating and Fixed Spreads
Brokers may offer two types of the spreads, floating and fixed. A floating spread, as it sounds, means the spread will constantly change but remain within a certain rage most of the time. Taking Euro-Dollar as an example, the floating spread may range between 0.5 pips to 2.5 pips.
On average, it is likely to be 1.8 pips. The spread is likely widen during economic figures due to the low market liquidity. It is difficult to predetermine how wide the spread may be but it could very well exceed +10 pips in currencies such as EURUSD. A floating spread resembles real market conditions as the spread is never fixed.
A fixed spread is a spread that will not ‘float’ most of the times. A fixed spread for EURUSD varies due to the great competition amongst forex brokers so we will refrain from providing what is considered as a standard fixed spread for the pair. Some traders find comfort in knowing the spread will not constantly change and a scenario in which the spread widens to over +10 pips is unlikely.
Only under extreme market conditions such as the Us Non-Farm Payrolls (NFP) fixed spreads are likely to widen, which is a not a fault in the system. Most of the fixed spreads in today’s market are provided under market-making conditions. We will soon elaborate on how brokers can manipulate the spread in order to post losses to their clients, which is often labelled as stop hunting operations.
Stop if Bid, Stop if Ask
Unfortunately, many experienced traders still do understand how the bid and ask affect the take profit and stop loss orders in their trading strategy. When you place a long position (a buy trade) in the market, in order exit the trade you must sell. Likewise, if you place a short position (a sell trade), to exit the market you must buy.
Long Trade Example
After understanding this concept, let’s take a long position as an example:
EURUSD long @ 1.2700
Take profit: 1.2800
Stop loss: 1.2650
Trade size: 10,000 units (0.10 lots in the MT4)
The price that will be used to trigger either the take profit or the stop loss is the bid (selling price). When a long position is executed in EURUSD, $10,000 are converted into Euros, which means you are selling US Dollars and buying Euros.
When you close the trade, you are converting the Euros back into US Dollars, which means you are selling Euro’s and buying back US Dollars. Because you require to sell Euros in order to close the trade the bid price is used.
The price that you see in the charts is the bid. Therefore, when EURUSD price reaches 1.2800 (the take profit) in the charts, the trade will be closed. The same applies for the stop loss order. However, when you short EURUSD the ask (buying price) will be used for the stop loss and take profit orders and it is not the price you see in the chart.
Short Trade Example
EURUSD short @ 1.2700
Take profit: 1.2600
Stop loss: 1.2750
Trade size: 10,000 units (0.10 lots in the MT4)
If you see on the chart EURUSD reached 1.2600 (take profit for the short position) but the trade did not close, remember it is due to the market spread.
As we explained earlier, the ask price (buying price) in order to exit the trade. The price on the charts is the bid and not the ask. In order for the take profit at 1.2600 to be triggered, Euro-Dollar must reach 1.2600 + the spread. For the stop loss to be triggered, the price must reach 1.2750 + the spread.
If the spread is 2 pips, the take profit for the short trade would be 1.2602 and stop loss would spring into action when the price reaches 1.2752. Now, what will happen when the spread widens by +10 pip? The price would need to reach 1.2612 for the take profit to kick in and to be stopped out, the price must reach 1.2760, which are ten pips above the set stop loss.
Stop Loss Hunting
Dishonest market makers will deliberately widen the spread to target their traders’ stop loss orders. Stop loss hunting is not limited to market makers. Any broker that does not deliver its traders’ orders to the market has the ability to stop hunt.
It is difficult unearth brokers that are conducting stop hunting operations using the spread but it is not a sufficient reason not to disregard the usage of stop loss orders. We suggest bearing in mind these possibilities when determining the trade size and the location of the stop loss.
There are several platforms that allow traders to place the stop loss on the bid if they are selling and place the stop on the ask if they are buying. It is called ‘Stop if Bid’ and ‘Stop if Ask.’ The majority of platforms however such as the MetaTrader4 (MT4) do not have these features so it is essential to understand the market spread when you are entering the market.
Please also note that the majority of trading platforms provide the forex rates with a fifth decimal point, which is a fraction of a pip. Therefore, if you wish to set a stop loss order of 1.2750 it would be 1.27500. A take profit of 1.2800 would be 1.28000.