The Dynamics of Change, Understanding the Spread

Certainly many people are aware of what a spread is and most people know that in times of high volatility and high market action the spreads on currency pairs in the currency market widen. People also know that when no one trades the spreads become smaller. Where does all this behavior come form ? Why does the spread change and how can we predict spread changes ? What determines the spread ? Today’s post will be focused on addressing this simple but yet very important questions in the world of forex trading. Not only is understanding the spread important for successful trading, it is also important in order to understand how market players work and why the effect of the market is that or another.

Let us start by defining what the spread is. The spread, as many of you know, is the difference in cost between the Bid and the Ask price of a currency pair. It is the “commission” kept by the dealer which is simply the difference between the price at which it sells and the price at which it buys. Why is there a spread ? Obviously because exchangers want a profit for their job. Their job is to provide you with a currency for another and you pay them by offering them the currency at a lesser value or buying the currency at a larger value. However, what determines the spread ?

What determines the spread is nothing more than supply and demand. The dealer demands a certain “price” or spread for his service, which is X. If supply and demand is equal, then the dealer gets X for each transaction and nothing bad happens. However, what happens when demand is much higher than supply within a small period of time or vice versa ? Well, the effect is that the Bid or Ask price of a currency in the interbank market can change so fast that the two can invert and the dealer can have himself dealing with a negative spread. That is, an arbitrage opportunity would arise in which you could just buy and sell and get a profit or vice versa. The dealer’s solution to this problem is simply to raise the spreads so that the risk of such an event happening becomes minimal. If there is a high volatility within a certain period of time, the dealers calculate the spread they have to use in order to be “safe” and prevent this possible profit opportunities which will come at a great cost to it.

Of course, you can understand that this will become very important also if there are many people using an automated trading system or trading at the exact same time. If people are buying or selling 100 lots of a currency at any given time they will greatly tilt the demand/supply scale and the brokers will raise their spreads to account for this. Many EUR/GBP and EUR/CHF scalpers which aimed at profiting from the Asian session have found this now to be the case with brokers raising spreads as a response to profit taking by large masses in this previously very much “not traded” time space. This was covered in much more detail in a post I wrote a few months ago about the Asian trading session and how the market was changing to adapt to the use of scalpers and similar trading techniques.

As you can see, understanding the spread gives a sense of how the market becomes efficient and how market players react to the conditions around them. After all, the forex market is nothing more than a game of supply and demand and knowing how these two components interact to generate the market is something which is not only interesting but highly useful in understanding the inner workings of the foreign exchange.

If you would like to learn more about systems that are not very much affected by the spread and can generate you long term profitable results with realistic profit and risk targets please consider buying my ebook on automated trading or subscribing to my weekly newsletter to receive updates and check the live and demo accounts I am running with several expert advisors. I hope you enjoyed the article !

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