If you are new to the world of Forex trading or seeking to deepen your understanding, then you've come to the right place. In this article, we will delve into the concept of spread and its pivotal role in Forex trading.
As one of the fundamental aspects of the foreign exchange market, spread refers to the difference between the buy and sell prices of a currency pair. Understanding how spreads work is essential for making informed trading decisions and maximizing your potential profits.
Throughout this article, we will answer what is spread in Forex trading by exploring it's various facets, including its calculation, types of spreads, factors influencing spread, and its impact on your trading experience. By the end, you will have a comprehensive understanding of spread's significance within the Forex market and how it directly affects your trades.
In This Article
- What Is A Forex Spread
- Two Types Of Spread
- Fixed Spread
- Variable Spread
- How To Calculate Spread In Forex
- Market Liquidity And Its Effect On Spread
- Impact Of Leverage On Spread
- Summary
What Is A Forex Spread
Spread is a essentially a small cost built into the buy and sell prices of a currency pair and acts as commission earned by the broker for placing a trade on behalf of a trader. To demonstrate, it is important to remember that when placing a trade, their is always an opposing position being taken. Lets say for example that a trader is looking to buy EUR/USD and current buy and sell prices offered by a broker are as follows:
Let's assume that a buy position of 100,000 units of EUR is being placed using an online Forex broker. As the trade is placed, somebody else will be selling 100,000 units of EUR, this ensures a controlled flow of money. However, if there is somebody not currently selling 100,000 units, the broker will honour the position and have to continue to look for a seller. This involves risk on behalf of the broker as they may have to accept a higher sell order than the buy order they have committed to filling. This leaves exposure to a potential loss. In an attempt to be able to afford these losses they charge a spread / commission on every single trade that is placed, this is also how the broker makes a profit.
Looking at the example above, assume that a trader enters a buy position at 1.13255 and changes their mind, immediately selling at 1.13245. The difference is 0.0001, a single pip that is visually displayed under the buy/sell prices. Read our guide on Forex pips and their value for more information.
What this ultimately means from a trading point of view is that as soon as you place your trade, it is at a losing position equal to the spread, the trade will have to move in the forecast direction by an equal number of pips for the trade to reach a breakeven.
Two Types Of Spread
There are two types of spread that may be offered when trading:
Fixed spread is offered only major financial institutions and market movers that buy large positions and offer them to their customers in small lot sizes. This enable the broker to control the prices they offer.
Offering a fixed spread means that the cost of trading is not susceptible to market conditions and remains consistent during periods of market volatility. A fixed form of Forex spread is often preferred by novice traders as calculating transaction costs is more straight forward. It allows novice traders to enter the market with small levels of capital, due to the smaller trade sizes required.
If an online broker is being used variable spread is the only option offered to traders. As the name suggests, the level of spread offered varies in line with market conditions. Wether a spread is offered as tight or wide, will depend entirely on market conditions i.e. changes in volatility and fluctuations in demand and supply.
How To Calculate Spread In Forex
Being able to calculate spread when Forex trading is important, as it has a direct impact on the potential profitability of a trade. Luckily, the calculation is simple! Spread is calculated by subtracting the bid from the ask, using the fourth pip. To make things even easier, most online brokers will display the spread within the trader screen, automatically adjusting it to reflect current market conditions.
The bigger the difference between buy and sell prices, the wider the spread. It will soon become apparent that major currency pairs like EUR/USD have tighter spreads than the minor currency pairs. It is important that consideration is given to the level of spread is acceptable and included with a trading strategy.
Liquidity And Its Effect On Spread
We have established that the spread is a cost to the trader as it represents a commission to cover the brokers risk. As with any business it is necessary to minimise costs and exposure to risk, the same is true of the spread. In the example shown above the spread is 1pip and is about as tight as you can expect. This is because we have used EUR/USD as the example, the most traded and liquid currency pair available, with hundreds of millions of dollars traded daily. Due to the liquidity of the paid, there is not much risk from the brokers point of view as there will always be a buyer and seller waiting to take a position.
Not all currency pairs are as liquid as EUR/USD and the lesser traded currency pairs will be offered with wider spreads. This means a larger initial trading loss for the trader as the position will be required to move further in the forecast position to reach break even point. With most major currency pairs this will still be quite small, in the range 1-3 pips, however, if you look to start trading the minor currency pairs, you will see that the spread can become significant, reaching perhaps 15-20pips and more.
If considering minor currency pairs, a trader will ensure that the spread complies with the trading criteria set out in the trading strategy, particularly if day trading is the preferred approach. Recovering a large spread could take several hours or days before you start realising a profitable trade, it is for this reason that minor currencies are often not considered for short term trading.
Another factor to consider even when trading the major currency pairs is that the spread is changeable so always double check before confirming your position. In times of uncertainty, particularly political, the spread can change quick and drastically. In recent months we have seen elections, Brexit and the global pandemic cause large fluctuations on the level of risk brokers are prepared to trade with. Uncertain economic factors and unexpected news releases can also have an impact on the spread as liquidity providers like ourselves do not know everything!
Impact Of Leverage On Forex Spread
Referring back to the above example you may be thinking that a single pip spread is nothing to worry about, particularly if trading in mini lots of 10,000 units. If trading in small volumes, a pip cost could be as little as £1, but many traders utilise the leverage that online Forex brokers offer to buy large positions, using only a lightly funded account. Some brokers will allow leverage up to 100:1 meaning that a £1,000 account will able to trade up to 100,000 units subject to margin requirements.
Increasing a trading position using leverage, increases the value of spread equal to the level of leverage. If a trader initially trades 10,000 units with a pip cost is £1 but decides to leverage their position to 100,000 units, the pip cost become £10. Assuming the spread is 1pip this means that the value of the spread has increased from £1 to £10. Imagine increasing the position further to 1,000,000 units and a pip cost of £100. We can now understand the importance of the relationship between leverage and spread.
Summary
A forex spread is the difference between the bid price and the ask price of a currency pair and is usually measured in pips. Knowing what factors cause spread to widen is crucial when trading forex. Major currency pairs are traded in high volumes so have a smaller spread, whereas exotic pairs will have a wider spread.
