How Spread Structure Affects Your Bottom Line as a Trader

 

Fixed Spreads vs. Variable Spreads

When looking for a prospective broker, it is important to research how they price their spreads. Over time, the spreads that a trader pays ends up costing a significant amount, and should be a key consideration when choosing a Forex broker.

Forex brokers generally offer two types of trade spreads, variable or fixed. So, which is the better option? Opinions differ amongst traders and it does depend on individual trading styles. First, let’s look at the difference between the two spread structures.

With variable spreads, the difference between the buy and sell price of a particular currency pair fluctuates in a range. A variable spread for the EUR/USD pair generally differs between 1 to 4 pips for most brokers, but during volatile market conditions can actually widen to as much as 8 or even 10 pips. A variable spread widens in correlation with increased liquidity in the market and is really only low during times of market inactivity.

On the other hand, fixed spreads are predetermined and remain constant throughout all trading conditions. A fixed spread will usually fall within the range of a variable spread, and is commonly set at either 2 or 3 pips for EUR/USD. Though traders essentially pay a small premium during quiet market hours, when a variable spread may be lower, the broker ensures that the spread will not widen during even the most volatile market conditions. Fixed spreads allow traders to better strategize without factoring in an unpredictable variable that inflates transaction costs during times most critical to traders.

 

Quiet versus Volatile Markets, What Kind of Trader are You?

Variable spreads may be more suited to long-term traders who do not trade during news events and are prone to entering and exiting during quiet market conditions. This way they can more consistently obtain a price that is in the lower range of the variable spread. For example, if a trader were to enter the market during off-peak times with a variable spread of 1 or 1.5 pips on EUR/USD as opposed to the fixed 2 or 3 pip spread on many platforms, he would save money on the spread in the long run.

  • 100 trades at 1 pip (or 1.5 pips) = $100 ($150) in spreads
  • 100 trades at 2 pips (or 3 pips) = $200 ($300) in spreads

However, flat markets and off-peak times are periods of consolidation when it is less clear where the price will head next. Most traders prefer to place positions when a clearer direction is evident in the market.

During swift market activity, especially around important fundamental releases such as a speech by a central bank official or the opening of local business hours and stock exchanges, spreads are widened to the upper part of their ranges. Likewise, during breaks of key technical levels, the market may also be very volatile sometimes moving as much as 100 pips in as little as 5 minutes. During these vulnerable times, opening positions becomes more expensive, which can be a deterrent to trading.

Consider this example: A trader prefers to enter and exit the market more when it is reacting to key news and events. He opens 100 positions of EUR/USD; he places 20 trades at a spread of 1.5 pips, 20 at 2 pips, and 30 each at 5 and 8 pips, when the spread has widened to the upper part of its range.

  • 20 trades at 1.5 pips = $30 in spreads
  • 20 trades at 2 pips = $40 in spreads
  • 30 trades at 5 pips = $150 in spreads
  • 30 trades at 8 pips = $240 in spreads
  • 100 trades at avg. (4.6 pips) = $460
  • All together the 100 trades cost $460.
  • 100 trades at fixed 2 pips = $200 in spreads.

With a fixed spread those same trades would have amounted to a cost savings of $260. This is a very simple case, but highlights the point that it depends a lot on the kind of trader you are and if you prefer trading during busy fast moving markets or times when the market is calmer.

 

Variable Spreads and Stops

Variable spreads may even set off protective stops and limits unwittingly. If the difference between the Bid and Ask widens and reaches the level of a stop or limit, this large gap may suddenly execute a conditional order. This adds an extra variable to your strategy that you need to consider. This might be less likely to occur with fixed spreads because the Bid and Ask are always synchronized. Fixed spreads minimize the element of surprise; traders know exactly what the parameters are at all times, allowing for better strategic planning and money management.

 

The Verdict

Tight, competitive spreads affect your bottom line as a trader, and the best spread structure for you depends on your trading style, appetite for risk, ability to react in a fast-moving market, and ultimately, the quality of execution. Fixed spreads are consistent and predictable regardless of market liquidity. On the other hand, variable spreads tend to provide lower costs only during quiet market conditions—times of limited market activity when traders may have less incentive to trade. CMS Forex offers one of the lowest fixed spreads in the industry; EUR/USD and USD/JPY are offered with a spread of just 2 pips. Coupled with the commitment to offering quality execution, CMS Forex remains a truly competitive player in the Forex arena. Perhaps you are interested in trading during a stagnant market or simply prefer the most popular brand name. The choice is yours.

©2004-2010 Globicus International, Inc. This report is intended for distribution to customers of Globicus International, Inc. Any information in this report is based on data obtained from sources considered to be reliable, but no representations or guarantees are made by Globicus International Inc., with regard to the accuracy of the data. The opinions and estimates contained herein constitute our best judgment at this date and time, and are subject to change without notice. Globicus International Inc. accepts no responsibility or liability whatsoever for any expense, loss or damages arising out of, or in any way connected with, the use of all or any part of this report. No part of this report may be reproduced or distributed in any manner without the permission of Globicus International, Inc.

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