Ever questioned what the word “spread” in forex means? The idea of spread might be very confusing to someone who is new to trading. When I initially learned about it, I recall having no idea what it was or how to calculate it. But relax; you’re not by yourself. In this article, we’ll examine the definition of spread in forex and the way it is calculated. So let’s get started and clarify this key trading idea!
What is Spread in Forex?
Every currency pair exchange in forex has a small commission known as the spread embedded into the buy (bid) and sell (ask) prices. The difference between the buy and sell prices that can be noticed when analyzing the price stated for a currency pair is known as the spread, which is also referred to as the bid/ask spread.
Pips, or any change in a currency pair’s fourth decimal place (or second decimal place when trading pairings listed in JPY), are used to measure changes in the spread. The total cost of your deal is determined by both the spread and the lot size.
Wider spreads signify greater divergence between the two prices, which generally translates to low liquidity and high volatility. On the other hand, a smaller spread signals good liquidity and minimal volatility. Trading a currency pair with a tighter spread will therefore result in a lower spread expense. The spread can be either fixed or variable while trading forex. When the bid and ask values of a currency pair change, the spread for those currency pairs also changes because the spread is a variable.
How Do You Calculate Spread in Forex?
In a price quote, the buy and sell prices’ most recent large numbers are used to compute the spread. With a CFD trading or spread betting account, you cover the entire spread when trading forex or another asset. Contrast that with the commission paid when trading share CFDs, which is paid both when a trade is entered and exited. You receive higher value as a trader the narrower the spread is.
For instance:
- For the GBP/USD currency pair, the ask price is 1.26749 and the bid price is 1.26739.
- The result of subtracting 1.26739 from 1.26749 is 0.0001.
- The spread equals 1.0 because it is predicated on the final huge number in the price quote.
The Factors That Affect Spread
The following variables affect the spread in forex:
- The asset’s liquidity at the time of trading
- State of the market
- The financial instrument’s trading volume
The underlying asset that is being traded affects the spread in forex. An asset’s market is more liquid the more it is exchanged. The spreads are lower or “tighter” depending on how liquid the market is. The gaps are typically greater in markets with minimal liquidity, or “thin” markets, like the natural gas market.
In line with the state of the market, spreads also change. In times of significant volatility and macroeconomic news, spreads are typically wider. Expect bigger spreads if you intend to trade while the Federal Reserve is ready to make a statement or the European Central Bank is holding a meeting.
As we mentioned before, some brokers offer fixed spreads; nevertheless, it is crucial to keep in mind that some brokers might not be able to guarantee that their spreads will remain stable during macroeconomic announcements and instances of high volatility.
Finally, the spread may be influenced by volume. The market maker will probably adjust their spread to account for the additional risk they are incurring if your trade is so significant that it influences the market against you. Retail trades are highly unlikely to affect the market price because forex markets are so liquid in nature.
How To Quote Spreads in Forex?
Let’s take an example of a quote for EUR/USD. The bid/sell price is $1.1200, and the ask/buy price is $1.1250.
Spreads can be either narrower or wider based on the currencies involved. The 50 pip difference between the ask and bid prices for the EUR/USD example is very wide for this currency pair. The typical spread between both of the prices is between 1 to 5 pip. However, the spread could shift or fluctuate at any time depending on the status of the market.
Investors must keep an eye on a broker’s spread because any risky deal must earn or pay the spread and any associated costs. Additionally, each broker has the choice to boost their spread, which increases their profit on each trade. If the bid-ask spread was wider, a customer would spend more when buying and receive less when selling. In other words, since each forex broker may impose a little different spread, the price of forex transactions may increase.
Is Spread Important While Trading?
Anyone who wants to trade forex must choose the trading strategy that suits them the most. Do you favor trading quickly, maintaining positions for only a few minutes or even seconds? Or how about trading over a longer period?
Depending on your trading style and technique, you will be more or less sensitive to the cost of the spread. The spread is a crucial consideration when trading for day traders like scalpers. These traders must frequently join the market during the day, therefore if the spread is too big, it can significantly reduce their potential gains.
The spread will have less of an effect on your profits the longer the duration you trade. For instance, the spread won’t have much of an effect on a swing trader who hopes to generate a larger profit over the course of days, weeks, or even months. This is because the spread is small in relation to the scale of the market swings they are hoping for. Spread fees can accumulate for traders who constantly enter and exit the market. If this is your trading approach, you must make sure that you place your orders when the spread size is at its best.
It is typically a good idea to take advantage of more indicators when trading with technical indicators to validate the signals provided by your main indicator. A spread indicator can be used by traders who enter the market regularly as a “final filter” to make sure they are not entering at a terrible moment for spreads.
Conclusion
A forex spread, which is typically expressed in pips, is the distinction between a currency pair’s bid price and ask price. When trading forex, it is essential to understand the causes of the spread widening. Major currency pairs trade frequently, resulting in a narrower spread than exotic pairs, which trade less frequently. To better understand all this check out these two articles:
