Understanding floating spreads
One of the most important concepts to understand when trading FX is the concept of floating spreads, which refers to the difference between the bid and ask prices of a currency pair.
Unlike fixed spreads, which remain constant regardless of market conditions, floating spreads fluctuate in response to changes in supply and demand. This means that the spread between the bid and ask price can widen or narrow depending on market conditions and trading activity.
The main reason why spreads are floating in FX trading is to ensure that the market remains efficient and liquid. By allowing spreads to adjust in response to market conditions, brokers and traders are able to more accurately reflect the current supply and demand for a particular currency pair.
However, if there was suddenly an influx of buyers looking to purchase GBP/USD, the demand for the currency pair would increase and the spread would likely narrow. Conversely, if there were more sellers than buyers, the spread would likely widen as the market tried to balance supply and demand.
The size of the spread can also affect a trader’s profitability. A smaller spread, such as a 0.1 pip spread, means that a trader can enter and exit a trade with less cost. In contrast, a wider spread means that a trader will need to generate a larger profit to offset the increased cost of the spread.
Floating spreads also provide traders with greater flexibility and the ability to take advantage of market opportunities. For example, if a trader believes that a currency pair is undervalued, they can place a buy order and benefit from any potential price appreciation.
Overall, floating spreads are an essential component of FX trading that helps to ensure market efficiency and liquidity. By allowing spreads to adjust in response to market conditions, brokers and traders are able to more accurately reflect the current supply and demand for a particular currency pair. It’s important for traders to monitor the size of the spread when executing trades and to factor in the cost of the spread when calculating their potential profit or loss.
Brokers, spreads, types of execution
In the world of forex trading, some brokers offer fixed spreads, while others offer floating spreads. The choice between the two types of spreads depends on the business model of the broker and the current market conditions. Having in mind there are more than two types of brokers and more than 2 types of spreads.
Let us cover those types and bring more clarity in relation to Brokers, execution types, and spreads:
Execution Methods:
- Market Makers: Market makers create a market for traders by acting as counterparties to their trades. They often provide fixed spreads and can execute trades quickly.
- STP (Straight Through Processing) Brokers: STP brokers route traders’ orders directly to liquidity providers, like banks or other brokers, without intervention. They can offer variable spreads that might be tighter during periods of high liquidity. STP brokers aim to provide faster and more transparent execution.
- ECN (Electronic Communication Network) Brokers: ECN brokers connect traders to a network of liquidity providers and other traders. This creates a more transparent trading environment and often results in tighter spreads. Traders can see the best bid and ask prices available and might even participate in price aggregation.
- DMA (Direct Market Access) Brokers: DMA brokers provide traders direct access to market order books. This allows for more control over trade execution and potentially tighter spreads. DMA is often favored by licensed, professional traders and institutions.
Spreads:
- Fixed Spreads: Brokers offering fixed spreads maintain a consistent difference between the bid and ask prices, regardless of market conditions. This can be advantageous during times of high volatility when variable spreads might widen significantly. Fixed spreads provide predictability but might be slightly higher than variable spreads during normal market conditions.
- Variable Spreads: Brokers with variable spreads offer bid and ask prices that fluctuate according to market conditions. Spreads tend to be tighter when market volatility is low and wider during times of high volatility. Variable spreads can be more cost-effective when trading under favorable conditions but may become expensive during volatile periods.
- Floating Spreads: Floating spreads are a type of variable spread where the difference between bid and ask prices can change dynamically in response to market fluctuations. This provides more flexibility but requires traders to monitor market conditions closely.
- Raw Spreads: Some brokers offer “raw spreads” or “raw pricing,” which means they generally result in extremely tight spreads, but brokers may charge a commission in addition to these spreads.
Fixed spreads are essentially predetermined spreads that remain constant regardless of market conditions. This means that the spread between the bid and ask price does not change even if there are significant changes in supply and demand. This can be advantageous for traders who prefer to have certainty in the costs of their trades, as they know the exact cost of executing a trade beforehand.
Fixed spreads are typically offered by market maker brokers, which means they take the other side of the trade and effectively create a market for their clients. Market maker brokers can offer fixed spreads because they have control over the pricing of the currency pairs they offer and can set the spreads to allow them to derive fees on trades.
On the other hand, floating spreads are offered by electronic communication network (ECN) brokers or straight-through processing (STP) brokers. These brokers typically do not take the other side of the trade and instead act as an intermediary between their clients and liquidity providers, such as banks and other financial institutions. As a result, the spreads are determined by the market forces of supply and demand.
Typically, under an STP arrangement, there is an expectation that any trades are automatically sent on or hedged to market. The term ‘ECN’ has taken on a similar meaning. At Eightcap, although our prices are formed using an electronic communications network, clients are dealing with us as principal, irrespective of our risk management strategy. This means that we set the prices and trading conditions that we are prepared to offer our clients. To confirm, we offer Floating Spreads on our Standard Account type and Raw Spreads on our RAW Account type.
Floating spreads can be advantageous in volatile market conditions, as the spread can narrow when trading activity is high and widen when trading activity is low. This means that traders may be able to execute trades at a better price when there is high liquidity in the market.
Overall, the choice between fixed and floating spreads ultimately depends on the trading strategy and preferences of the individual trader. While fixed spreads offer certainty in the costs of executing trades, they may be less competitive than floating spreads. Conversely, while floating spreads can be more competitive, they can also be more volatile and unpredictable in times of market turbulence. It is important for traders to carefully consider the pros and cons of each type of spread before selecting a broker and executing trades.