Why do we need a spread?

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NAGA Trader

It is like being on a classical market: Whenever you buy something, you want to sell it with a profit, right So when I now want to make profits and I am certain that the EURUSD will rise, you need to imagine that you buy EURUSD only to sell it later at a higher price to someone else. As stated, your price will be the ASK price when you buy, which is at 1.11628. 

You now decide to buy EURUSD with $500 investment. In order to realize any profits, you hope that EURUSD will rise to 1.12000 for instance. If you think about it, it's not even a "cent"! So if you have $500 and it just rises by one cent, you will not make any big cash.
Now especially in Forex, there is a given rule that the price is structured in a specific way and there are two main things:

 

 

a) Leverage effect

The leverage effect is like a "multiplier". In FX/CFDs the brokers are basically "lending" you money so you can move a higher amount and benefit from smaller market movements.
If you deposit $500, the broker calls it your "security margin". This is the amount of equity you need to have in your account for a specific position, and now the broker will "leverage" your margin by 100. This means your leverage ratio is 1:100, and you will be able to trade with: $500,00 * 100 = $50,000. Meaning that by investing (depositing) $500, you are able to move a volume of $50,000.

Thanks to the broker‘s leverage ratio you will be able to buy fx or cfds symbols worth of $50,000 by only having $500 in your account to back up this transaction. Now also its important to say that every symbol can have different leverage ratios. Usually, FX (Cross pairs like EURUSD) can have 1:50 up to 1:2.000! Whereas stocks or equities cfds have usually 1:5, 1:20 etc, as the so called "margin level".

Technically they say a margin level of 1 %, this is nothing else then a 1:100 leverage written in percent and stated how much margin (your real own cash) needs to be on your account to back and secure a single position.

So far so good: The broker indeed makes you richer as you are. If you deposit $10,000 to your account and you have a leverage on FX of 1:100, you can move $1,000,000, which makes you a millionaire TRADER.

 

WHY DO BROKERS MAKE ME RICHER? AND WHY THEY TAKE SUCH RISK TO LEND ME MONEY

Easy: They earn on the bid/ask spread and the higher the traded volume, the more they can benefit of smallest price movements. 

b) Pip Value

If we now go back to "Pip Value" you will see the effect. As stated we want to buy EURUSD with a $500 investment.
Sell (bid price):1.11516 / Buy: (ask price):1.11628

Now we aim that the EURUSD rises to 1.12000 and thus we can SELL it a higher price. This is exactly where the difference between buy and sell kicks in. You can only SELL something that you bought at the current Sell (bid) price as no one in the market is ready in this moment to pay you a higher sell price that 1.11516. That means if you accidentally bought EURUSD at 1.11628 and the best sell price you will get is 1.11516.
This is absolutely lower than 1.11628, it is exactly 1.11628 - 1.11516 = 0.00112 lower! (Aha looks like the bid/ask spread!)

Now as you moved $50,000 of volume, you have bought at a higher price and can POTENTIALLY in best case on market get rid of your position when you sell at a price that is lower by 0.00112 than your entry price!
How much cash is that? 0.00112 * 50,000 = 56$
This means, in the moment where you entered the EURUSD position the best price you can get to sell is $56 lower than the price you paid. 

This is also the reason why whenever you open a position it is first "negative". And you Profit & Loss statement (P&L) is at - $56.
You need thus wait until the SELL(bid) price rises to 1.11628 to equalize your position. Only if the sell (bid) price now rises higher than 1.11628 you will start making a profit.
If you now had a leverage of , lets say, 1:1000, You would have moved $500 * 1000 = $500,000.

Considering bid/ask spread of 0.00112, then the current difference to your purchase price would be : $500,000 * 0,00112 = $560. 

This means you would be short of MORE than you already invested in the deal. Due to the spread you would burn a complete investment only by opening and closing a trade Thus: You need to wait until the future sell price will rise higher than your entry (buy) price.

 

LEVERAGE AND REQUIRED MARGIN

Because leverage multiplies your investment amount, this means that the trade size is reduced by the amount of leverage that you have.
If you have no leverage (1:1), it means that to place a 100k trade of EUR/USD, you would need to physically have at least €100,000 in your account. The use of leverage reduces this requirement.

𝑇𝑟𝑎𝑑𝑒 𝑆𝑖𝑧𝑒 (𝑢𝑛𝑖𝑡𝑠) 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = Base Currency Required Margin


If you want to determine the required margin in the TERM currency of the pair, you would multiply by the current exchange rate.
𝑇𝑟𝑎𝑑𝑒𝑆𝑖𝑧𝑒 (𝑢𝑛𝑖𝑡𝑠) 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 * Market Price = Term Currency Required Margin

Summary:
The value of each ‘Pip’ is determined by the trade size that you place. Trade size may be quoted in ‘Lots’ or ‘Units’ depending on the platform. The units represents the value of BASE currency you are either buying or selling. 1.0 lot is equal to 100k of the base currency of the traded pair.

 

 

GOLDEN RULE IN TRADING

You always BUY at ask price, you always sell at bid price. You always sell at the bid price and buy at the ask price. The spread shows you the delta of how much you need to wait to make profits or too see how much you lose.

Now in fx, you see that there are 5 decimals. We differentiate between 3 digit and 5 digit pairs on FX and all other instruments.
EURUSD is a 5 digit pair: 1.11568 (bid) 1.11628 (ask)
USDJPY is a 3 digit pair: 102.167 (bid) 102.427 (ask)

Now, this has an effect of how the "pip" value is showed.
Pip is called "percentage in point" and it is for a 5 digit currency always the fourth decimal and in a 3 digit currency or also for cfds the second decimal. The pip value is a good indicator of how much money you can calculate to lose or win with. In EUR/USD if the bid price is 1.11568 and ask price is 1.11578 then= 1.11578 - 1.11568 = 0.0001 (the spread is one pip).

If you now have $500 with a leverage of 1:100, you will buy a volume of 50,000 and every PIP movement of (0.0001 = 50,000 * 0.0001 = $5 ) is worth $5. So whenever EURUSD is moving by a single pip up or down you make +$5 or lose -$5.
In a 3 digit currency, the second decimal is a pip. Same goes to USD/JPY.

Example on pip value:
1.14192 -> Price now changes to:
1.14197 (price has now increased by half a pip (0.5 pips).
1.14187 (price has now decreased by a pip (1.0 pip).
1.14199 (price has now increased by 1.2 pips.

 

WHY WE NEED RISK MANAGEMENT?

As you see, a tiny price movement combined with the leverage and the specific pip value can cause big losses. This is why NAGA TRADER encourage everyone to set a Stop Loss and Take Profit Level.

 
*Risk/Profit*

On NAGA TRADER we offer the chance to set your risk and profit levels in amount or by price. Both values correspond to each other.

Let's assume again that you buy EURUSD at 1.11628. Now you know that you can only make a profit when the BID (SELL) price will be higher than your buy price you entered the position with.

If you want to make for example a profit of $100, The future sell price needs to be: 1.11828

Let us take a look at how we come up with this number:
1.11828 - 1.11628 = 0.00200 (20 pips).
Every PIP = 5 $
Volume of 50.000 * 0.0020 = 100 $ or 20 pips* $5.
If you now also want to limit your losses to $100, then the future sell price should be at not lower than 1.11428: 1.11428 - 1.11628 = -0.00200
0.0020 * 50,000 = - $100!

It's basically like: You buy something with the hope of a rising price. If the price to sell is higher than the price you bought at, you realize a profit. Otherwise, you realize a loss. Both, the profit and the loss can be restricted by setting a Stop Loss and a take Profit.
As mentioned, NAGA TRADER ask users to set a Take Profit or Stop Loss - This can be done either to set an amount in account currency ("I want to make 100 $") or by the rate ("I want to sell at a rate of 1.1178").

The main difference between traditional stock trading is that we offer our users the possibility for BUYING and SELLING. If you buy, you bet on rising price. You enter at ask price and you can only leave the position at the sell price. We say you "go long". You can however bet on falling prices and "go short".

 


 

If you need further assistance, please do not hesitate to contact our staff.

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