Advancements in the forex industry seem to occur at such a pace that we hardly have time to adapt to them. And as the industry evolves, the process of trading becomes more accessible and the costs of doing so appear to be getting smaller.
With more investors now showing an interest in forex trading, with an increasing liquidity and with price aggregation now almost common practice, it has become possible for brokers to charge less for their services and advertise spreads as low as 0 pips.
And for professional traders, who naturally want to incur as few trading costs as possible, such advertisements are often tempting. But do, or should, lower spreads matter the most to traders?
What is spread
The spread, that is, the difference between the bid and the ask prices of a financial instrument, is essentially how a broker gets paid for providing you with access to the market.
There one thing that’s equally, if not more important than low spreads
It is a cost you incur instead of, or at times together with, being charged a commission fee for the trades you place. Spreads, however, are not only determined by how much a broker charges for trading a particular instrument, but also by the available liquidity in the market.
During normal market conditions, the difference between the bid and the ask price of a particular instrument remains generally stable, with the most popular, heavily-traded currency pairs usually having the lowest spreads.
If, however, there is significant imbalance between supply and demand, spreads may widen considerably. The same is also observed during times of illiquidity or when a major market event takes place, such as a change in interest rates.
As a trader, you’d be right to look for a broker that offers low spreads. After all, spreads play a significant part in the profitability of your trades and, if you’re like every other trader out there, the smallest difference in price matters a lot to you.
BUT. And there is a big but
There is at least one thing that’s equally, if not more important than low spreads, and that’s solid and reliable order execution.
See, in order to benefit from a broker’s low, advertised spreads, you would first have to actually see such spreads on the platform.
High-quality order execution ensures that spreads the broker advertises and which are the ones you trade on
Secondly, your order would have to be executed at the price you see when you click ‘Buy’ or ‘Sell’, and not a number of pips away. Let’s look at this in more detail.
Fast and reliable order execution guarantees that, at least for the most part, your request to buy or sell a specific instrument gets filled at the price level you see.
This means that you do not experience slippage or are not constantly receiving requotes, both of which are entirely normal and at times even expected during high market volatility but should not frequently interrupt your trading in normal market conditions.
In other words, high-quality order execution ensures that the spreads that the broker advertises and which you see are the spreads you trade on.
Yet, this would hardly be the case if you experienced delays in execution. With asset prices changing by the millisecond, it would be next to impossible for your order to be executed at the requested price if the quality of execution offered by your broker was not optimal. And while the price level at which your order is eventually executed may be just a few points away from the requested price, the fact that you’re trading on margin maximises the value of those points lost, or, points not earned.
Take an example:
Say you register with a broker that advertises a spread of 0.5 pips on EURUSD.
This does not mean that the spread remains at such a level at all times; rather, it means that this is the lowest spread you will see offered on this particular currency pair, unless, of course, you’re trading on a fixed-spread account (on which, again, the spread may widen during high market volatility). So, you log onto your trading platform and see the following prices:
EURUSD Bid: 1.11525
EURUSD Ask: 1.11530
EURUSD Spread: 0.5 pips
Say, now, that you place an order to buy 10 lots of EURUSD at 1.11530.
Pip value: $100 | Spread cost: $50
In the milliseconds that pass between your request to buy and the moment your order is filled, the price changes to 1.11532. The reason behind this could be the quality of execution offered by your broker, or the unavailability of enough liquidity at the Top of the Book price level (that is, the level that the broker alludes to when he advertises his EURUSD spread of 0.5 pips).
Now, 0.2 pips slippage may not seem like much so you do not complain. The market moves in your favour and once the Bid price reaches 1.11560 you decide to sell the 10 lots of EURUSD. Though it seemingly does not take more than a few milliseconds for your broker to execute your order, this time you experience a slippage of 0.3 pips, eventually getting filled at 1.11557. To sum up:
Request to buy at 1.11530 | Request to sell at 1.11560
Order filled at 1.11532 | Order filled at 1.11557
All in all, you made a profit of 2.5 pips, which translates into $250. If your orders were filled at the price levels you requested, however, you would have made a profit of 3 pips, or, $300.
And, while your broker did seem to offer a spread of 0.5 pips to you, you ended up trading on a spread of 1.0 pip after experiencing slippage of 0.5 pips. Imagine, then, if your order was filled several pips away, and how quickly spread costs would add up when opening multiple positions each day.
See, lower spreads do matter a lot in forex trading, yet what matters most is the speed and likelihood of execution, the likelihood of you being able to actually take advantage of such spreads.
Indeed, one may be trading for months before actually managing to benefit from the low spreads that a broker supposedly offers, with slippage essentially translating into paying for higher-than-average spreads.
At the end of the day, it is wiser if you look at the spreads available at a broker in combination with what else this broker has to offer.
Suppose, for example, that broker A offers lower spreads than broker B, but the latter also provides you with access to a trading platform that is far superior to the one available at broker A, as well as with fast and reliable order execution, a variety of trading tools, daily market analysis and around-the-clock customer support.
It may just be better to pay slightly more for the spread but enjoy a far superior trading experience, than go after the lowest spreads and sacrifice other benefits.
The article was written by Electra Georgiades. Learn more about execution here.