Forex Pip Spreads Explained

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.

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, an! d thus i ncreased 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.