What is Forex?
Foreign Exchange (Forex or FX) is the trading of national currencies against one another. Foreign exchange transactions take place on the foreign exchange market, also called the forex market. It is the largest and most liquid market in the world.
The forex market has no centralised location but is rather an electronic network where banks, governments, central banks, brokers, large commercial companies, institutions, and individual traders are trading in foreign currencies. Individual traders are mostly trading through brokers or banks.
What is a spread in forex?
A spread in forex comprises two prices: the bid price (the buying price) and the ask price (the selling price). The bid price is what a forex broker is willing to pay for a currency, while the ask price is the rate at which a forex broker will sell the same currency.
Put differently: the bid price is the price at which you (the forex trader) can sell the base currency, while the ask price is the price at which you can buy the base currency.
A spread in forex refers to the difference between the bid and ask price of a currency pair. The difference is also called bid-ask-spread. The spread is the cost of each transaction that the forex broker charges and is the basic compensation for each broker. Vice versa, the spread represents the cost to the trader.
Basically, a spread represents the supply and demand for currencies. The bid price reflects the demand, while the ask price reflects the supply.
A currency pair is when the value of one currency is quoted against another currency. The first listed currency of a currency pair is called the base currency and the second currency is called the quote or counter currency. The quotation indicates how much of the quote currency is needed to purchase one unit of the base currency.
For example: If it takes ZAR19.20 to buy US$1, the expression ZAR/USD will equal 19.2/1 or 19.20. The ZAR is the base currency and the USD is the quote or counter currency.
How to calculate the spread in forex?
Formula to calculate a forex spread: Ask price minus bid price.
The spread is usually measured in pips, the most basic unit of measure in forex trading.
Most currency pairs are quoted to the fourth decimal place. A pip represents the last of those four numbers and thus equals 0.0001.
Calculation example: In a currency pair the EUR, the base currency, has a bid price of 1.0931, while the USD, the quote or counter currency, has an ask price of 1.0934. The spread is 1.0934 – 1.0931 = 3 pips.
Why is spread important in forex?
Forex spread is a valuable concept to learn when you start off as a forex trader because it determines future costs you will have to face as a trader.
A trader that trades with low spreads will have less operating cost and long-term savings. A high spread trader will have to generate higher profits to offset the cost. For many traders, the spread is particularly important within their losses and gains.
You must factor in the spread to your potential profit outcome before you trade. For example, if a trade will cost you 5 pips then you have to cover 5 pips minimum before you can make a profit.
In fact, a spread is a direct initial loss for the trader and the strategy should be to cover the loss during the following trading.
For example, the currency pair quote for EUR/USD is 1.0905/1.0910. The spread for one lot, in this case, is 5 pips. To recoup the loss, you want the subsequent currency pair quote to change in your favour by at least 5 pips.
By calculating the forex spread you can determine if the cost is appropriate for your trading style and if you have proper trading strategies in place.
Forex spread is also one of the most important things to check when deciding on a forex broker. According to Finance Magnates, “all investors and traders should be educated about the lack of information regarding the possibility of manipulating the spreads on their (forex brokers) trading platforms without the consent of their clients. On certain occasions, there are unscrupulous brokers who exercise this practice to obtain more profits.” Therefore, selecting a quality broker with a good reputation and not guilty of spread manipulation, is essential in forex trading.
High spread and low spread
- A high spread is when there is a relatively high difference between the bid and ask price. In general, currency pairs in emerging markets have a high spread compared to major currency pairs. Major currency pairs trade in higher volumes compared to emerging market currencies, and higher trade volumes tend to lead to lower spreads under normal conditions.
Higher than normal spreads are normally indications of high volatility or low liquidity in the market.
- A low spread indicates there is a small difference between the bid and ask price.
Low spreads are generally indications that volatility is low, and liquidity is high.
Entering a forex trade when the spread is relatively low, implies you start the trade with a slightly better overall position.
Before big news events or during a big shock (Covid-19 pandemic), spreads can widen to a great extent.
Types of spreads
- Fixed spreads stay the same, regardless of what market conditions are at any given time.
Usually, a fixed spread is set for the most liquid currency pairs like EUR/USD, USD/GBP, and USD/JPY, where average spread fluctuations are not significant.
Among others, fixed spread advantages are: Smaller capital requirements, calculation of transaction costs is more predictable, traders can rely on strategies without anxiety about unexpected variables.
Disadvantages are, inter alia: More frequent requotes because your broker will not be able to change the spread to accommodate new market conditions and it cannot be used during forex scalping.
Scalping is a trading method used by traders to buy or sell a currency pair and then hold it for a short period of time in an attempt to make a profit.
- Variable spreads are set by the broker within a lower limit and may fluctuate. Changes in the currency value may also influence a variable spread.
Some advantages of variable spreads: No requotes, more transparent and better pricing by having access to prices from different liquidity providers.
Disadvantages of a variable spread, to name a few: Increased trading risks because a spread may look profitable but can reverse in an instant, it is actually only low during market inactivity since a variable spread broadens with increased liquidity.
In high volatility markets, fixed spreads will always be the better choice.
What influences the spread in forex trading?
Some of the factors that can influence spreads in forex:
- The currency pair involved. The major currency pairs like EUR/USD, USD/GBP, and USD/JPY tend to have the tightest quoted dealing spreads.
- In forex markets with a higher volume dealing spreads tend to decrease because this implies that more traders are involved as buyers and sellers in such a market.
- Levels of volatility in the markets. Market players, quoting prices in a volatile market take on a greater risk in doing so and so quote broader prices to compensate. Volatility in the markets can be driven by news about events like referendums, elections, and disasters, like the impact of a pandemic.
Frequently Asked Questions
How do you make sure that you are paying the lowest spread?
When pricing forex brokers it is important to take into account both the spread and the commission. A broker who appears to have low spreads might turn out to be more expensive than a broker with slightly higher spreads. It is important to calculate the final price after you have factored in the commission costs.
What are the disadvantages of trading with a fixed spread broker?
a Broker who offers fixed spreads will not sacrifice profits for a trader’s sake. You may end up locked into high spreads which is a huge disadvantage for any trader. Although fixed spreads sounds good, it is mainly targeted at beginners who lack trading experience.
Do major currency pairs have lower spreads?
The major currency pairs have the most trading volume and as a general rule, the more a currency pair is traded, the lower the spreads tend to be across all the brokerages.
What is the meaning of high spread in forex?
High spread in forex trading is an indication that a currency pair is less liquid than other pairs, meaning that there are fewer traders who are focusing on that currency pair. Less frequent trading leads to an increase in spread.
Do forex brokers include their trading fees in the spread?
Yes, they do and traders should be aware that even if a broker presents itself as a “commission-free” forex trading platform, trading fees may be included in the spread.
Table of Contents
Toggle