Forex Pip Spreads Explained
10/05/2011 6:00 am EST
The narrowing of bid/ask spreads in recent years has helped level the playing field in forex trading, reducing costs to traders and improving profit potential in the world’s most liquid market.
A lot of changes have been taking place in the foreign exchange market over the last couple of years. Volume has increased to the tune of almost $4 trillion, execution is lightning fast, and technology has become a staple in a market once run by copper wire phone lines.
In addition, and above all else, the cost of business has also improved. The spread, or the difference between the bid and ask prices on platforms, has always plagued traders trying to make it or break it in this 24-hour market.
See related: How to Trade for Maximum Pip Gain
However, with the advent of all of the recent changes, bid/ask spreads are shrinking and will likely continue to play an increasingly important role in the profitability of any trader's strategy and end-of-year profit and loss (P&L).
Cost of Doing Business
First and foremost, any trader will tell you that commissions and spreads are the underlying cost of doing business. Just as any grocery store that pays taxes and shipping costs for produce, traders are always made to pay fees for transactions in the market.
Particularly in the foreign exchange market, spreads are charged over commissions as brokers and market makers establish both buy and sell prices. In the last ten years or so, the difference between these prices has been relatively wide.
Taking a look back, it wasn't uncommon for a retail FX trader to see EUR/USD buy and sell prices trading five pips apart. The funny thing is, FX brokers offering this spread even said it was the tightest and most competitive at the time. As a result, a retail trader would be paying a rather hefty cost for initiating one standard lot position.
However, in the last few years, spreads have narrowed considerably. Due to increased attention, and thus increased volume of the foreign exchange market to the retail audience, liquidity has jumped. Surprising some in the market, in 2009, volume had risen to almost $4 billion in daily turnover. This has increased the amount of providers in the market as well.
As a result, banks and institutions are now more than willing to compete and offer the best prices and even narrower spreads to their clients. Referring back to our example above, a EUR/USD position can now cost approximately 60% less at some brokers, which offer the spread cost at a mere $20 for one standard position.
NEXT: Pros and Cons of New, Variable Pip Spreads|pagebreak|
Another consideration of spreads involves the recent implementation of new processes sponsored by banking institutions. Now, instead of market makers and dealers offsetting trades, many banks have made it easier to aggregate all of the retail positions for the broker.
See related: Do Market Makers Still Matter?
As a result, many brokers have decided to offer pricing that is close to prices offered in the actual interbank market. These prices, as such, will fluctuate in sync with larger market prices and help to narrow the spread.
- Better Pricing: FX quotes are a direct reflection of interbank market prices
- Narrower Spreads: Most brokers operating under this process offer spreads as small as 1.5 pips to 2 pips on major pair transactions
- A Better Feel: Variable spreads offer insight into market conditions. If spreads are narrow, there is plenty of liquidity to be had. However, if spreads are wide, all-around execution may not be as good as it is with light volume in the market
- Fluctuating spreads means that the costs of entry can vary. Sometimes the retail trader will pay two pips, while others can pay five pips, depending on market conditions
- Variable spreads mean that some strategies will be thrown out the door as stop and limit orders are subject to price availability and fixed spreads on charts
Trading within the Spread
Once disallowed by many retail brokers, some FX firms have now allowed trading within the spread itself. Typically not a consideration for the longer-term position trader, the flexibility has given scalpers and short-term traders a new avenue for profit. Previously, scalpers would shun the simple retail platform due to its restrictions.
If an opportunity arose, the price at which the scalper preferred it would not be honored, as market makers sometimes placed a minimum distance of where certain orders were placed.
For example, should a short-term speculator want to place a sell limit four pips away from a buy entry, the order would be rejected as the order would have to be placed approximately five to six pips away from current prices. As a result, not only would the trader be subject to higher risk-taking, it would almost ensure that the transaction would lose out.
However, all that has changed. As spreads get tighter, forex brokers are being more forgiving in that area and are allowing scalpers to place buy and sell orders in between the spread. This allows for more liquidity on the broker's side (more orders to possibly match) and a new avenue of profit for the scalper.
Now, with risk somewhat manageable and restrictions erased, a scalper can implement a short-term strategy in the market with ease.
What Does the Future Hold?
If the current trend in the market continues, retail traders may be in for some pretty hefty changes in the industry beyond 2011. Other than technology and execution improvements on proprietary platforms, retail traders will likely see currency trading spreads narrow even further.
Increased competition by banks and currency brokers, as well as increased volume by traders, will likely push institutions to provide better and better pricing. Subsequently, the changes should help retail traders in both the short and long run as new strategies surface and the bottom lines of many trading portfolios will be boosted by cost savings.
By Richard Lee, contributor, Investopedia.com