The Importance of Swaps & Spreads in FX
Before opening a trading account, it is important for a trader to know as much as possible about the offering of that respective broker, and what the costs associated with Forex trading are. Managing a trading account should mean considering not only set-ups and execution for profitable trades, but also what other factors will affect an account’s balance. Swaps and spreads fit into this category, and they really need to be properly understood before opening a trading account with any broker.
Defining the Spread
As mentioned in other articles here on the Forex Trading Academy, the spread is the difference between the ask and the bid price of a currency pair, or between the price a currency pair can be bought at and the price it can be sold at. Let me give you an example: If the bid and ask prices for the EUR/USD pair are 1.12301 and 1.12314 respectively, the spread is the difference between the two, namely 1.3 pips. In other words, if one opens a trade and closes it in the same instant, with time for the prices time to change, the loss in the trading account will be –1.3 pips. Therefore, the smaller the swap is, the more attractive that type of account/broker is to the retail trader, as trading costs will be smaller. This swap is, in most trading accounts, a mark-up that the Forex broker adds to the prices it can get, and represents part of the broker’s income.
Are There Different Spread Types?
Spreads are calculated based on the type of Forex broker your broker is, and there’s no way of getting around them. If the broker you’re trading with is a market-maker (these brokers virtually make the market for their clients in the sense that they are trying to match client’s orders with the liquidity-provider’s orders in order to see if there’s a match; and if there’s no match, the market maker will effectively take the opposite side of your trade) or a dealing desk, the spreads will be fixed, and this is going to be the first thing that is advertised. Fixed spreads are a good thing, especially when it comes to fast-moving markets such as the foreign exchange markets, but as a rule of thumb, fixed spreads offered by market-makers are bigger than those offered by brokers who use the Straight Through Processing (STP) and Electronic Communication Network (ECN) technologies to get their quotes. A typical spread under these conditions starts from around 1 pip for the EUR/USD (the lowest spreads are always on the EUR/USD pair) and rises gradually for other currency pairs, with spreads of up to 4 or even 5 pips for currency pairs such as GBP/CHF, or other exotic currencies for which the broker will not have many orders to match with the liquidity provider’s orders. If the broker does not offer fixed spreads, it means it is most likely a no-dealing-desk broker, or an STP or STP+ECN broker.
Under these conditions, the broker will have direct access to the interbank market, with no dealing desk in between, and will try to match the orders with orders from other market participants, such as banks, hedge funds, and even other brokers. Because of that, quotes of different currency pairs will vary from liquidity provider to liquidity provider and, depending on the moment during the trading day, the spreads will be bigger or smaller. In this case, the spreads will be sensible lower but they will differ significantly during a trading day. Important economic news will result in wider than usual spreads, and also the fix at the end of the day will be characterised by wide spreads.
Zero or No-Spreads
Can it be that any broker is offering zero or no spreads? The answer is yes. Why don’t all traders open a zero-spread account, then? The answer is that the spreads are not really zero, but they do tend to be really small. This is one thing. The other thing is that brokers are not doing their work for free and will therefore charge a commission for every trade that is opened, regardless of whether the it is going to be a winner or a loser. Unfortunately, there are brokers who charge a commission on top of higher spreads as well, even though they advertise as being no-dealing-desk brokers. These brokers need to be avoided at all costs, as they will overcharge clients.
Defining the Swap
Swaps are as tricky as spreads are, as no one really talks about the costs associated with keeping positions open overnight. The very definition of a swap is the difference between the different interest rates in a currency pair. Do not take that definition word by word though, as it is not really the exact arithmetical difference – it takes into account different factors as well. However, the swaps are mostly negative these days, as interest rates are at exceptionally low levels, and even in negative territory in some parts of the world, so at the end of a trading day any open position will see an amount being deducted from the trading account. This amount is directly related to the volume of that open position.
Some time ago, when interest rates were higher, the concept of carry trade was invented as large institutions, money managers, hedge funds pundits, etc., tend to invest heavily in keeping orders of currency pairs that paid a positive swap open for long periods of time. The purpose was to simply gain the yield given by the positive interest difference.
Other educational materials
- How to Enter/Exit a Trade
- How Do I Make a Profit from Forex Trading?
- Forex Market Terminology
- Profit from Forex Trading Using Different Trading Styles
- How to Set Up an Expert Advisor
- HFT (High-Frequency Trading) in Forex Markets
Recommended further readings
- Counterparty risk for credit default swaps: Impact of spread volatility and default correlation. Brigo, D., & Chourdakis, K. (2009). International Journal of Theoretical and Applied Finance, 12(07), 1007-1026.
- “The market price of risk in interest rate swaps: The roles of default and liquidity risks.” Liu, Jun, Francis A. Longstaff, and Ravit E. Mandell. The Journal of Business 79, no. 5 (2006): 2337-2359.