What is Spread in Forex Trading?
The most common method for Forex brokers to make money is through spreads. The majority of them have fixed spreads, which ensures a consistent income. The wider the spread, the more money is earned by the Forex broker.
A spread is an expense incorporated into the purchase and sale prices of all currency pairs or other assets. A trader might expect less money from their trading activity the wider the spread is.
The most popular spreads are floating and fixed spreads. Based on changes in the market and trends, the floating spread is always changing. On extremely rare situations, such as during recessions or changes in monetary policy, the fixed spread might alter.
In this article we will try to explain what Forex spreads are, the best ways to use them and how to calculate them.
What is a Forex spread?
The spread in foreign exchange is a small fee incorporated into the purchase and sale price of every currency pair transaction. In other terms, the Forex spread is the difference in price between the purchase and sale of a currency pair.
When you examine the quoted price for a currency pair, you will notice a difference between the buy and sell prices. This difference is the spread or the bid/ask spread.
Every forex transaction entails the purchase of one currency pair and the sale of another. The bid price is the cost of purchasing the base currency, whereas the ask price is the selling price. The magnitude of the spread is dependent on market volatility and the currency pairs you intend to trade. Typically, in a volatile market, spreads are wider, consequently, increasing your transaction costs.
Pips, or any change in a currency pair’s fourth decimal place, are the units used to measure changes in the spread. The spread and the lot size both have a role in determining your trade’s overall cost.
Forex trading accounts and spreads
Forex traders offer two types of trading accounts, depending on the size of the spread, namely a Standard no-commission account or a Direct account with commissions.
Standard no-commission account
With this account, brokers do not charge traders for commission. Traders keep all the profits that they make from a trade, because the cost for trading is included in the spread.
Direct account with commissions
With some brokers, traders have access to raw spreads. These spreads are lower as there is no extra cost added to the spread. But for this privilege, traders need to pay a base commission fee to brokers.
Types of Spreads in Forex
In most trading platforms you will typically find two types of spreads and this depends on the forex broker and how they make money. The two types of spreads are fixed spreads and variable or floating spreads.
Variable spreads are provided by brokers operating a “non-dealing desk” model, while fixed spreads are typically provided by brokers operating as market makers or “dealing desks”.
Brokers that use a market maker or “dealing desk” approach will offer fixed spreads. Fixed spreads always stay the same, no matter what is going on in the market. Using a dealing desk, the broker buys big positions from their liquidity providers and sells these positions to traders in smaller sizes.
When a forex broker has a dealing desk, they can offer set spreads because they can control the prices they show their clients. Fixed spreads take less money to start trading, so traders who don’t have a lot of money to start trading can save money by using fixed spreads. When you trade with set spreads, it’s also easier to figure out your transaction costs.
Since fixed spreads never change, you’re always sure of what you can expect to pay when you open a trade.
There are also disadvantages with fixed spreads. If you try to make a trade at a certain price, the broker will “block” the trade and ask you to accept a different price. The requote message will show up on your trading platform to let you know that the price has changed and to ask if you are still ready to accept that price. Usually, it’s a worse price than the one you asked for.
Another trouble is slippage. When prices change quickly, the broker can’t keep a set spread, and the price you end up with after entering a trade will be very different from the price you planned to enter at.
The difference between the bid and ask prices of currency pairs fluctuates with variable spreads. Non-dealing desk brokers provide variable spreads. These kind of brokers buy currency pair pricing from numerous liquidity providers and pass these prices on to traders without the involvement of a dealing desk.
This indicates that they have no influence over the spreads. And spreads will broaden depending on currency supply and demand as well as overall market volatility. Spreads typically widen during economic data releases and other times when market liquidity is low.
The advantage of variable spreads is that it eliminates requotes. It also provides more transparent pricing, especially when you consider that having access to prices from multiple liquidity providers usually means better pricing due to competition.
Unfortunately, variable spreads aren’t ideal for scalpers. The widened spreads can quickly eat into any profits that the scalper makes.
What is the difference between Spreads and Commission?
The spread in Forex is regarded as one of the finest solutions for both brokers and traders, but this does not imply that there are no alternatives. Commission is an alternate method. Spreads and commissions are frequently highly varied depending on the broker you trade with.
The key cause is most likely the spread guarantee and the unpredictability of commissions. When the spread is fixed, you as a trader know exactly how much you will pay for the broker’s services. When you’re on commission, however, things might change quickly. For example, your deal could increase overnight, resulting in a commission, or it could reach a deadline, resulting in a commission, or you could mistakenly terminate the trade too early, resulting in another commission.
Overall, bid ask spreads may be slightly more expensive at first glance, but commissions are much more likely to cost you more in the long run.
Why do spreads change?
Fixed spreads normally do not change, but floating spreads do. When there is a market shift, it will change the spread. For example, if there is a news story in which the United States government announces a big increase in interest rates, forex brokers are likely to respond to this news by lowering spreads on USD currency pairs. The reason for this is because they want to boost their volume of USD trades in order to qualify for interest rate bonuses.
Other factors that influence a healthy spread in Forex include market trends and recessions. If the market thinks that a particular currency pair is far more significant to trade, a Forex broker is likely to boost the spreads on it, because a large number of people are trading it, and the demand may raise their income. This corrects the market, and people finally diversify into different currency pairs.
In terms of recessions, Forex brokers might simply pick one major currency pair and give the greatest possible spreads on it.
Calculating spreads in Forex trading
To calculate the spread in forex, you must determine the difference in pips between the buy and sell prices. To achieve this, deduct the ask price from the bid price.
Spreads come in two varieties: wide/high and tight/low. The spread widens as the number of pips from the calculation increases. Tighter spreads are frequently preferred by traders since they make the trade more inexpensive.
It is fairly easy to calculate spreads and all you need are the value per pip and the number of lots you’re trading.
For instance, you would lose 1.4 pip if you bought EURUSD at 1.35640 and sold it at 1.35626 right away. You would multiply the price per pip by the quantity of lots you are trading to get the overall cost.
In this case, your transaction cost to open this trade would be $1.40 if you were trading tiny lots (10 000 units), where the value of a pip is $1.
The price per pip is linear. This implies that you must multiply the price per pip by the quantity of trades you are doing. Your transaction cost, which is reflected in the spread, will increase if you expand the size of your position. For instance, if you trade 5 micro lots and the spread is 1.4 pips, your transaction cost will be $7.00.
Pros and Cons of Spread
Spread forex trading is easily accessible
Flexibility in terms of trading hours
Traders can use leverage
Offers diverse trading options
The forex market has high volatility
Leverage is an advantage but it also increases the risk of losses
The forex market is decentralized
Spread costs can be high
In conclusion, a forex spread is the primary cost of a currency trade, built into the buy and sell price of a forex pair. Spreads are measured in pips, which is a movement at the fourth decimal place in a forex pair’s quote. To calculate a spread, subtract the buy price from the sell price.
Forex spreads are mostly variable, or fixed and can be either wide/high or tight/low. Traders often favour tighter spreads, because it means the trade is more affordable. If a market is very volatile and not very liquid, wide spreads may occur, but if a market has high liquidity but is not very volatile, tighter spreads may occur.