Spread in forex
Any foreign exchange transaction involves exchange of one currency for another currency and the price quoted in a foreign exchange market is in the form of currency pair. For example: If an individual wants to purchase Australian dollars in exchange US dollars, he would need to consider the rates between AUD/USD currency pair.
The first currency in the currency pair is the base currency and the second currency is known as the quote currency in the currency pair. The price of the currency pair would be the amount of quote currency an individual requires to buy one unit of the base currency in the pair.
Any trading in foreign exchange market is based on two prices available in the market. The two prices are known as bid and ask. The ask price represents the price at which the foreign exchange market will sell the base currency in exchange of the quote currency. The bid price represents the price at which the exchange market will buy the base currency in exchange of the quote currency.
Concept of forex spread
In order to understand what is spread in forex, it is essential to have an understanding of the two prices prevalent in the foreign exchange market. Since, spread implies the difference between the price at which an individual can purchase currency pair from the market and can sell a currency pair in the market.
In simple words, it is the difference between Bid and Ask price in the market. The Ask price in any foreign exchange market is slightly higher than Bid price, therefore, a clear understanding of the forex spread is imperative for individuals trading in the foreign exchange market to have the lowest spread between the prices of the currency being traded in the market.
The value of a spread in a foreign exchange market is determined on the basis of the prices that the market participants are willing to pay in order to purchase or sell currency pair prevailing in the market. The market makers in foreign exchange market make huge profits by entering into deals wherein they quote the bid and the ask price to their client and retain the spread for themselves.
Types of foreign exchange trade
There are different forms of spread in the foreign exchange market. The different forms of spread are the fixed spread, the variable spread and the fractional spread. In case of fixed spread, an individual can understand the nature of the spread before entering into the deal with its broker.
For example : The broker might keep the foreign exchange brokerage for AUD/USD fixed at 3pips. If the actual amount increases the broker will bear the extra to ensure a fixed spread throughout. There are brokers who offer variable spread. The variable spread fluctuates with the prevailing market conditions. In case of higher liquidity, the variable spread can be lower, whereas in case of lower liquidity the case would just be the reverse.
Fractional spread implies that the broker is using five decimal places. It means that the spread between the bid and the ask price can be 5.2 instead of 5 and it is irrespective of fixed and variable spread used by the broker. Fractional spread enables a broker to make a more exact quote for a currency pair and improves the execution of trades. In case of scalping foreign exchange trading software, the fractional spread can generate more trades for the broker.
In case of a variable spread broker, by changing the number of times of trade one can easily improve the spread. By trading in the market in times of higher liquidity, one can easily improve spreads. Changing broker can also help an individual to improve the spread for themselves.