What is Spread in Forex Trading?
Forex trading or foreign exchange is one of the most distinguished trading systems where traders use different international currencies for trading. Among other types of trading systems, Forex trading has shown a faster growth rate and attracted more traders to the market.
If you want to start trading in the Forex market, first, you’d better understand its important terminologies such as Forex spread.
In Forex trading, currencies are always quoted in pairs, i.e. XXX/YYY 1.2345. On the left side of this equation, we have the base currency, or X, and on the right side, we have the quote currency, or Y. The number next to the pair represents the value of the base currency in comparison to the quote currency. Let’s say that the EUR/USD pair is priced at 1.3500, which means 1€ is worth 1.35 US dollars. You should know that the base currency is always counted as 1 regardless of the other currency it is paired with.
When you engage in forex trading, you will have two sets of prices in front of you for the pair you are trading; that is to say, EUR/USD = 1.3500/1.3502. The left number is the BID price – the price at which you sell your currency to the broker, and the right number is the ASK price, the price that the broker will pay you to buy the currency. As you can see in the example, these two numbers are different in terms of value, that difference is called the Spread. And here’s how you can determine the exact spread amount for this pair based on the abovementioned values: 1.3502 – 1.3500 = 2 pips
For example, the exchange rate of the EUR/USD pair is set at 1.3501. The broker offers 1.3500/1.3502, meaning the broker is willing to buy USD at 1.3500, and sell it at 1.3502. Therefore, the spread of the EUR/USD pair is 0.0002, or 2 pips.
How does the spread work in forex trading?
Forex brokers charge a fee, or spread, for each transaction. So they earn their keep by marking up the prices by several pips. For instance, when the price of EUR/USD is at 1.3500, brokers will offer the pair at 1.3500/1.3503. As a result, the brokers will earn 0.0003 or 3 pips from their traders’ transactions.
Each forex broker will offer spreads under different trading conditions. Those who offer lower spreads (1 - 2 pips) usually require additional fees for services rendered. And then there are those who offer higher spreads without any additional fees whatsoever.
Of course, we shouldn’t disregard the inevitable effect that the currency itself can have on the amount of spread.
You need a Forex broker that offers the lowest spreads so you can reduce your trading costs and at the same time add to your profits.
Forex brokers offer two types of spreads to their traders, namely Fixed and Floating. It’s up to the traders to choose which type of spread suits their trading preferences better in terms of trading needs, objectives, capital, and of course experience.
1. Fixed Spread
A fixed spread will not change due to market fluctuations or volatility. However, if there are significant changes in the market, there will be some temporary changes in the fixed spread, meaning a new fixed spread level will be set until the market returns to its normal conditions.
Due to its less risky and more stable nature, the fixed spread may be a more suitable option for many traders. Nevertheless, bear in mind that fixed spreads are usually set at higher prices, 2-3 pips or more, and generally offered In a Micro Forex account.
2. Floating Spread
As the name suggests, the price value of a floating spread will constantly change depending on the market. At some point, it may be as low as 0.5 pips or even 0 pip. So the amounts can change greatly resulting in varying spikes in the market.
As a Scalper or a short-term trader, this type of spread suits your trades’ requirements better because the amounts are considerably lower than their counterparts. Furthermore, this type of spread is usually offered by ECN Forex brokers.
You might think to yourself, the amount of spread is so nominal, so why are they bothering me with this insignificant sum? Yes, it may seem that way in the case of a small-time trader who trades in smaller lot sizes; however, for a pro trader who trades in much bigger lot sizes that insignificant sum could make or break the bank. Let’s break it down with actual numbers so you can get the picture.
Say the price of EUR/USD is set at 1.3500/1.3502, in which case the spread will be 0.0002 (2 pips/unit). And also imagine that you want to buy the currency with 10 standard lots which will result in 10 standard lot = 1,000,000 units and therefore 0.0002 x 1,000,000 = $200.
In other words, as a result of your trade, $200 will go directly to the broker. That is why the amount of spread is very important. Thus, you need to carefully calculate your spread to minimize the costs of trading for more gain.
Additionally, forex spreads contain live data about the goings-on of the market in terms of liquidity, ups and downs, and volatility. These figures can tell you about particular trading times of currency pairs, and how the market is moving in general.
Why do spreads widen in the market?
The spreads in the Forex market see constant changes due to a number of reasons, such as newsworthy events and political issues on an international level. In other words, whenever there is notable volatility in the market, you can expect a certain upward or downward movement in the forex spreads (variable spreads). So you need to pay attention to these changes since the costs of your trade can significantly affect your ability to choose which trades to take and which to avoid. One thing that could be a potential help to you and you must read it as if it is your bible, is the economic calendar. The economic calendar can keep you informed of upcoming events, so it should be regarded as an indispensable tool in your arsenal.
Another important issue that you need to concern yourself with is market liquidity. Now, what is liquidity? And how can it affect your abilities as a trader? Simply put, liquidity is the interchangeability of assets and money in the market, so how liquid a market is will determine how easy or how hard it is going to be for you to open or close a trade.
