Unnoticed by many, a quiet revolution has been taking place in the forex market. As recently as five or six years ago, the typical interbank spread on a currency pair such as EUR/USD was five pips and the minimum ticket size was a million units. Today interbank spreads for EUR/USD can be as low as 0.8 pips with tickets as small as 100,000 units. That contraction in spreads is astonishingespecially when you consider that for market makers who dont charge a commission, the spread is their primary source of income. Not even personal computer prices have come down so far so fast.

But the revolution runs deeper: five, six years ago only a small, elite class with proper credit credentials could trade forex, and most of that was done over the phone. Today anyone can open a margin account, make a token deposit, and trade forex over the Internet with very small transaction sizes. And this with spreads on EUR/USD between 1.5 and 3 pips. And this dramatic trend in tightening spreads will likely continue. By next year, spreads of less than one pip on EUR/USD will become much more common; within a year or two the spread on this same pair could drop to 0.5. Perhaps the most astonishing part of all this is not the phenomenon of spread contraction, but how few traders understand spreads impact on their return on equity and the number of new trading strategies this enables.

The impact of spreads on ROE
A simple way to measure the impact of spreads is by their actual cost. With a spread of three pips, the trader pays the market maker 300 (units of the quote currency) for each million traded round-trip. With a spread of two pips, the trader pays only 200. For the occasional trader this may not mean much, but for active traders such a difference can add up quickly.

With five round-trip, one-million trades a day, on average, the difference comes to 120,000 a year. A more telling way to measure the cost of spreads is to consider their effect on annual return on equity (ROE). As an example, assume a trading strategy that results in 5 round trip trades a day using 2:1 leverage. If the annual ROE is 20% when trading on a platform with a 3 pip spread, then switching to a platform with a 2 pip spread will result in a 45% annual ROE when trading the same strategy, corresponding to a 125% improvement!