Understanding the concept of spreads and commissions is crucial for both novice and experienced traders. For most, the term may seem straightforward, but in the trading landscape, the spread can influence everything from your trading strategy to your profitability.
Either you have good trading conditions and low spreads and commissions, or poor conditions that can erode the profitability of your strategy, no matter how well you trade it!
This article aims to help you as a trader grasp the concepts of spreads and commissions in Forex and indices trading, why they matter, and how you can navigate them to avoid being taken advantage of!
What are Spreads?
In simple terms, a spread is the difference between the buying price (ask) and the selling price (bid) of an asset, quoted in pips (percentage in points) for Forex markets and points for indices. It serves as a cost of trading that traders must consider when entering and exiting the market.
Bid and Ask Price
To understand what spreads are, it’s important to understand what the bid and ask prices mean. The bid price is the highest price that a buyer is willing to pay for an asset. In contrast, the ask price is the lowest price a seller is willing to accept. The bid is always lower than the ask price, and the difference between these two prices is what constitutes the spread.
Why Spreads are Important
Cost of Trading
Spreads essentially represent the cost of trading. A wider spread means a higher cost, which could potentially eat into your profits or add to your losses.
Spreads can also be indicative of an asset’s liquidity. Generally, assets that are highly liquid have narrower spreads, while less liquid assets have wider spreads.
Your choice of trading strategy can be greatly influenced by the spread. Scalping, for instance, which involves making several trades in a short timeframe, requires a narrow spread to be profitable.
Types of Spreads
Fixed spreads remain constant regardless of market conditions. They are usually offered by market maker brokers and are generally wider than variable spreads but will often times have no commissions, so that the broker can still profit off of trades that you’re taking whether they’re A booking or B booking them.
Also known as floating spreads, variable spreads fluctuate based on market conditions. They can be narrow during normal market conditions but can widen significantly during news events or high volatility.
Spread Costs in Forex
In Forex trading, major pairs like EURUSD, GBPUSD, and the US indices typically have the lowest spreads. This is due to the fact that these are just extremely high volume pairs and instruments and because there is a ton of liquidity during the major sessions.
That’s not to say spreads don’t widen at certain times of day like any other pair, but typically in the heart of the session spreads are extremely low for these trading symbols.
Exotic pairs, on the other hand, can have wider spreads. These are pairs like USD/TRY or EUR/ZAR that involve a major currency and a currency from a smaller or emerging market economy.
Spread Costs in Indices
In indices trading, the spread can vary based on the index you are trading. Popular indices like the S&P 500, NASDAQ 100, and Dow 30 (US30) usually offer competitive spreads, while lesser-known indices may have wider spreads due to lower liquidity.
How Spreads Impact Scalping and Day Trading
For scalpers, who might make dozens or even hundreds of trades a day, a narrower spread is crucial. Even a one-point difference in the spread can have a significant impact on profitability.
Day traders, although not as frequent in their trades as scalpers, also need to be conscious of spreads. The spread can impact whether a strategy is viable over the short term.
Managing Spreads in Trading
Given that spreads constitute a trading cost, they should be factored into any risk management strategy. Failure to account for the spread can result in underestimated risk.
A trading strategy should be optimized considering the spread, especially for high-frequency trading where the cost will be magnified.
Broker/Prop Firm Selection
Different brokers offer different spreads. Therefore, choosing a broker that offers competitive spreads for the asset you intend to trade is crucial for reducing costs.
Understanding Commissions in Trading
Some brokers charge a flat fee per trade, regardless of the size of the trade. This is common in stock trading but can also be found in some Forex and indices markets. Knowing the flat fee in advance can help traders calculate their potential profitability more easily.
In contrast, some brokers charge variable commissions based on the size of the trade. This is usually expressed as a percentage. This model is often more favorable for smaller trades but can become quite costly for larger transactions.
Many modern brokers are now offering commission-free trading, making their money solely off spreads. However, traders should be cautious, as sometimes these brokers compensate by offering wider spreads.
Commission and Spread Combined
In some cases, brokers may charge both a commission and a spread. This is often seen in more professional trading environments and can be beneficial for traders who are executing larger orders, provided the spreads are tight.
How Commissions Can Affect Your Trading Strategy/Profitability
Just like spreads, commissions are a vital part of any trading strategy. High commissions can eat into profits and may make some strategies, like scalping, financially unviable.
Choosing the Right Broker/Prop Firm
Given that different brokers have different fee structures, it’s important to understand both the spreads and commissions before selecting a broker. Many brokers will list their fee structures on their websites, so a little research can go a long way.
By understanding both spreads and commissions, traders can make more informed choices and optimize their trading strategies for maximum profitability.
Spreads are more than just a term that traders throw around; they are a fundamental aspect that can significantly impact trading outcomes. Whether you’re trading Forex or indices, understanding the type of spreads, their costs, and their implications can equip you with the knowledge to optimize your trading strategy and maximize profitability.
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FX Trader & Analyst
Writer & Editor
Rob is a funded trader from Toronto, Canada, and has been trading currencies, commodities, stocks, and cryptocurrencies for over 7 years. Outside of trading, he enjoys making music, boxing, and riding motorcycles.