What are Fixed and Variable Spreads?
A fixed spread is a spread which remains unchanged regardless of the circumstances. A variable spread is based on the forex market. In a variable spread, the difference between the buy and sell price of a currency pair fluctuates in a range.
A fixed spread is usually within the range of a variable spread. For example, for EUR/USD trading, a fixed spread is 2 or 3 pips. Here, the trader ensures that the fixed spread will not widen despite volatility in the currency market. On the other hand, a variable spread for EUR/USD trading varies between 1 to 4 pips. In volatile currency market situations, this can go to as high as 8 to 10 pips. With increased liquidity in the market, the variable spread widens. During less activity, the variable spread remains low.
Choosing a Spread
For long term traders, variable spreads are a good option. This is because they can enter and exit the market during times of lesser activity. They can get a price which is on the lower end of the variable spread. For regular traders, fixed spreads are a better option, as they can escape the high and low variation during times of high activity.
However, there is no rigidity in choosing a spread as risk appetite, style of trading, execution quality and ability to react in volatile markets are the factors that affect your choice. Traders who like to deal in fast moving currency markets may choose variable spreads.
Fixed and variable spreads do not really matter so much to long term traders. This is due to the fact that in a longer time period, the difference of a few pips evens out. Experts feel that sometimes fixed spreads provide lesser incentives to traders, who have a higher risk appetite.
Cost Savings in Fixed Spreads
Despite the doubts over fixed spreads, forex traders do feel that these spreads provide cost savings. For example, a trader opens 100 trades of EUR/USD in a variable spread. He puts 20 trades at 1 pip, 40 at 2 pips and 40 more at 8 pips (when the market is volatile). His costs come to USD 420 in spreads (20 x 1 + 40 x 2 + 40 x 8). If he had chosen a fixed spread at 2 pips, then his costs would have come to only USD 200 in spreads (100 x 2). Thus, he would have saved USD 220 if he had used a fixed spread.
It is also known that in times of high volatility, traders can lose a lot of money if they use variable spreads. For novices, fixed spreads are recommended. When they get more comfortable with trading in the currency markets, then they tend to move on to variable spreads due the competitive nature of these spreads.
It should be kept in mind that poor execution can also ruin trades on fixed spreads.
Thus, it is recommended that all traders should have a clear strategy in mind before actually commencing with foreign currency trading.