Forex Low Spreads

Forex Low SpreadForex access providers often use low spread rates between currencies in order to attract and maintain forex trading clients.
Low spreads are important, but they don’t tell the whole story.

Here are some hypothetical scenarios to illustrate how trading costs and spread rates can be used in making the determination of which forex access provider or providers represents the best value for any particular trader.

The following two examples will be based on a 1000 unit transaction to keep the math simple.

Scenario 1.

Purchase 1000 units of EUR/USD at 1.3200. Each pip in price will equate to a $0.10 change in account equity. The broker’s spread is 2 pips. The market is pretty quiet, but does manage to work in your favor up to 1.3210. Rather than risk waiting forever to capture your profit, and anyone who trades the EUR/USD regularly knows that it can remain range bound for extended periods of time, you close your trade for a 10 pip profit and add $1.00 to your account.

The broker’s 2 pip spread is equal to 20 percent of your trade, which is fairly significant. Your net profit would be $0.80. If the market had moved against you, the broker’s cut would have been added to your loss instead of subtracted from your win. Your account would decrease in value by $1.20

The only way to reduce this percentage is to hold trades longer. If your profit in this hypothetical trade would have been 20 pips instead of 10, the broker’s cut would still be 2 pips, but would now only be $.040 from a profit of $2.00, equivalent to 10 percent.

The above scenario involves the use of a Money Maker Broker, whose only fees are derived from the spread. These spreads can be variable depending on the currencies involved and the volatility of the market. At times of high expected volatility, such as directly ahead of an important economic release, it is not uncommon to see spreads on the EUR/USD to be set at 10 pips or even higher.

Scenario 2.

Same transaction, buy 1000 EUR/USD at 1.3200 but instead of using a market maker, the access provider is and Electronic Clearing Network (ECN). The initial spread is much lower, just half a pip, but the ECN charges a commission of $4.00 per 100,000 units.

Since this transaction involves 1000 units, the commission would equal $0.40. The cost of the spread on a 10 pip profit would be $0.05, for a total of $0.45, equivalent to 45 percent of the $1.00 profit. The loss in this scenario would be $1.45.

In these two scenarios, it would cost less to trade with the Market Maker than the ECN, even though the ECN had a much lower spread.

Next, here is what would happen if the trade was for 100,000 units instead of 1000.

Scenario 3.

Each pip now equates to $10.00. A ten pip profit now equals $100.00. The broker’s cut on a two pip spread is $20.00, leaving a net of $80. The 20 percent rate still applies.

Scenario 4.

Buy 100,000 using an ECN with a half pip spread and $4.00 per 100,000 unit commission. The ten pip profit again has a gross profit of $100.00. The commission is now $4.00. The effect of the spread, however, is still the same one half pip, equal to $0.05, for a total of $4.05 cost for this trade, producing a net profit of $95.95.

There are many factors beyond the cost of trading to consider, but you can see that as your unit volume increases, you will be paying less to trade with an ECN, but a Market Maker is less expensive for smaller trades. Contact LucrorFx today for a Forex Investing consultation.

 

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