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Understanding Spreads

	Also See Spread Cost Calculator Questions to ask forex brokers Recent OANDA Spreads Comparing broker spreads

These days just about every forex broker claims to have the tightest spreads in the industry. But marketing-speak can be deceiving.

The topic of spreads in the forex spot market is surprisingly complex and often not well understood. Yet nothing affects your trading profitability more. In these pages, we bring some light to the topic after covering the basics.

What Is A Spread?

FIRST, spread is the difference between the ask price (the price you buy at) and the bid price (the price you sell at) quoted in pips. If the quote between EUR/USD at a given moment is 1.2222/4, then the spread is 2 pips. If the quote is 1.22225/40, then the spread is 1.5 pips.

SECOND, it is how brokers make money. Wider spreads result in a higher ask price and a lower bid price. As a consequence, you pay more when you buy and get less when you sell, making it more difficult to realize a profit

Brokers don't typically earn the full spread, especially when they hedge client positions. The spread compensates the market maker for taking on risk from the time it executes a client trade to when the broker's net exposure is hedged (possibly at a different price).

Why Are Spreads So Important?

Spreads affect the return on your trading strategy in a big way. Probably more than you think. As a trader, your sole interest is buying low and selling high. Wider spreads means buying higher and having to sell lower. A half-pip lower spread doesn't sound like much, but it can easily make the difference between a profitable trading strategy and an unprofitable one. You can use OANDA's Spread Cost Calculator to see how much spreads are costing you and how big a difference spreads make to your return.

Spread, Execution, and Depth: A Symbiotic Relationship

The tighter the spread, the better for you. But tight spreads are meaningful only when they are coupled with good execution. Quality of execution determines whether you actually receive tight spreads. Say your screen shows a tight spread, but your trade is filled a few pips to your disadvantage or is mysteriously rejected. When this happens again and again, it means that your broker is displaying tight spreads but is effectively delivering wider spreads. Rejected trades, delayed execution, slippage, and stop-hunting are strategies some brokers use to void the promise of tight spreads.

No less important, spreads must always be considered in conjunction with depth of book. Strangely, when it comes to economies of scale, forex doesn't behave like most other markets. On the interbank market, the larger the ticket size, the larger the spread tends to be. Hence, when you see a 1-pip spread on an ECN platform, you have to ask: is that spread valid for a $2M, $5M or $10M trade? Probably not. In many cases, the tight spread offered applies only to a capped trade sizes that are grossly inadequate for typical trading strategies.

Spread Policies: What You See?

Spread policies differ considerably from broker to broker, and the policies are often not exactly transparent. This makes comparing brokers exceptionally difficult. Some brokers offer fixed spreads that are guaranteed to remain the same regardless of market liquidity. (Caveat emptor: check the fine print for exceptions!) But since fixed spreads are traditionally higher than average variable spreads, you are effectively paying an insurance premium throughout most of the trading day for protection from rare outbursts of short-term volatility.

Other brokers offer traders variable spreads depending on market liquidity. Spreads are tighter when there is good market liquidity but widen as liquidity dries up.

Fixed or variable? The choice depends on your trading pattern. If you trade only or primarily on news announcements--when markets tend to be volatile--you may well be better off with fixed spreads. But only if quality of execution is good.

Some brokers have different spreads for different clients: those with larger accounts or those who make larger trades may receive tighter spreads, while clients referred by an introducing broker might receive wider spreads in order to cover the costs of the referral. Other brokers, like OANDA, may offer everyone the same spread regardless of who they are.

Problems arise in trying to discern a company's spread policy because this data--along with information on trade execution and order-book depth--is difficult to obtain. As a result, many traders get caught up in promises, taking a broker's words at face value. This can be dangerous. The only real way to find out is to try out various brokers or talk to those who have.

OANDA's Spread Policy

OANDA FXTrade policy is simple: to offer the tightest variable spreads possible with no discrimination. On FXTrade, everyone gets exactly the same spread regardless of account size or trade size or type of customer. And OANDA does not engage in the practice of providing hidden kickbacks to Introducing Brokers (IB) or white-label partners.

Further, OANDA's commitment to transparency is evident in platform features like real-time spreads clearly displayed next to quotes and published spread data from the last seven days (see Recent FXTrade Spreads).

How Can OANDA Keep Spreads So Tight?

Through fully automated trading, end-to-end. No direct human involvement. No dealer intervention.

OANDA FXTrade is electronically connected to numerous liquidity providers. It hedges client positions, and for every hedging trade, it automatically selects the provider with the most attractive price. These price savings are passed on to clients in the form of tighter spreads.

Finally, OANDA is a technological power house on two fronts: financial technology and computer technology. FXTrade is based on more than 15 years of currency market research and expertise. The platform comprises proprietary market-making and risk-management technologies that have made us a leader in our industry. On the computer technology front, FXTrade was designed from the ground up to (i) minimize per transaction costs, (ii) maximize throughput, and (iii) minimize trading latencies, while at the same time be as reliable as possible.

Call to Action

Switching to a broker with a better spread policy can result in a big payoff. The cost of switching is low -- essentially the cost of a wire transfer. What is the cost of not switching?

A proper competitive analysis is well worth it. But this takes time and effort, and possibly an investment. At the very least be sure to:

1. Understand what spreads are really costing you and how lower spreads would improve your return. You can use the OANDA Spread Cost Calculator for this purpose.
2. Understand the spread policies of various brokers. In detail. Asking the right questions is important. This Spread Questions for Forex Brokers will help you get started.
3. Understand different brokers' quality of execution--given your trading style. The best way to do this is to open an account with more than one and try them out. The cost will be money well spent. Alternatively, see what their existing clients have to say -- by asking for references, or consulting the broker's or market maker's (uncensored) bulletin board. Finally, try various brokers' demo platforms. But beware: demo platforms often execute much better than the real ones.

Final Thoughts

Ultimately, forex prices today are dictated by the forex interbank market, where spreads are variable depending on current liquidity and ticket size.

Some brokers try to simplify things by offering constant spreads and guaranteeing no slippage. That's fine. But there is no such thing as a free lunch. With a bit of investigating you can find out who's paying for this "guarantee".