Forex Spread Explained
It helps to know what the spread means in currency trading. One of the first decisions you face when you set out to trade the forex market is working out what you actually need for your trading journey. As financial markets keep shifting, trading has become demanding work unless it is backed by real plans and strategies that move you toward your goals. For more, read about Forex Scalping.
For most of us, when we buy or sell something, price is usually a big part of the decision. Yet the transaction costs built into that purchase or sale don’t always get the attention they deserve. This applies to forex trading just as it does to selling a house or buying a car. When we trade forex, one of the main transaction costs is, of course, the difference between the bid and the ask price.
A spread indicator lets you calculate the minimum, average and maximum spread for any currency pair over any period you want to analyse. When you compare how spreads change across different forex brokers, the indicator is very useful, especially when you decide to trade smaller foreign currencies such as the Japanese yen and the Swiss franc, because spreads on these pairs are generally wider.
What does the spread mean in currency trading?
The spread in currency trading can be described as a small cost built into the buy price (the bid) and the sell price (the ask) for every currency pair you trade. When you look closely at the quoted price of a currency pair, you’ll notice a clear gap between the buy and sell prices. When important forex news is about to be released, consider putting a spread indicator on the chart and watching what develops. You may be surprised at how wide spreads can get.
Read also: Trading with leverage — opportunities and challenges
You should also understand that traders can take advantage of how different parties value a given currency and profit from the discrepancy. In most cases, some forex trades follow the “greater fool” theory, which exploits environments where information is asymmetric. On top of that, the midpoint of a foreign-currency spread points to the theoretical price a trade would be at, and it can be worked out by adding the bid and ask prices and dividing the total by two.
For example, if a trader is willing to sell a certain number of units of a currency for the equivalent of US$1.50, while another trader only wants to buy a number of currency units for US$1.00 — the mid price — the exchange spread would be (1.50 + 1.00) / 2 = US$1.25.
Buying and selling currencies
The biggest difference between the stock market and other markets is that you don’t have to choose whether to buy or sell. By default, you always do both at once. In the forex market, every time you place a trade you are always buying one currency and selling another, because currencies are always traded in pairs.
The reason is simple. In the stock market, when you sell a share you swap it for money. In the forex market, money itself is the commodity being traded, so you simply exchange one type of money for another. The type of money you give up counts as sold by you, and the type you take in return counts as bought by you. Unfortunately, most beginner traders struggle to grasp that the forex market involves buying and selling currencies at the same time.
In short, trading in the forex market depends heavily on buying and selling currencies continuously. Once you buy a currency pair, speculators buy the base currency and sell the quote currency. The bid price represents the amount of quote currency needed to receive one unit of the base currency. On the other hand, when a currency pair is sold, the investor sells the base currency and receives the quote currency. So the sell price of a currency pair is the amount one would receive in the quote currency for providing one unit of the base currency.
Read also: Opening an account to trade digital currencies — proven methods
Why the spread indicator matters in currency trading
In trading, the spread indicator is one of the concepts to keep in mind in the currency market, because it can make a big difference to an investor’s or trader’s net profit. Most forex brokers also earn sizeable revenue through the spread. So you can think of the spread as the price you pay for your forex trade. To push the point further, bear in mind that if a broker has tight spreads or offers no spread, it will instead charge a commission.
In fact, many brokers today don’t charge what we traditionally understand as a per-trade commission; instead they make a profit from your spread. So keep in mind that some brokers charge both spreads and commissions. From the broker’s point of view, offering trading on forex spreads lets them make a profit without charging an actual commission on every trade. This no doubt adds to their appeal in their marketing campaigns.
The difference between fixed and variable spreads
A fixed spread stays the same most of the time regardless of market conditions. If your trading system relies on consistency, fixed spreads offer a clear advantage because they let you plan transaction costs more effectively. This matters especially for people who like to trade news events, where prices can be very volatile and spreads can vary widely after important news.
A variable spread simply tracks the best bid and ask prices available at a given time, with the amount of variation depending on the instrument traded and the broker used. Variable spreads are often cheaper than fixed spreads, especially in times of high liquidity. However, variable spreads can rise quickly in times of extreme volatility, such as news announcements and market open and close times.
Read also: Trading the US market — when and how
In general, it’s important to pay attention to transaction costs if you are a high-speed trader, simply because you have to pay the spread more often. This is the main reason many speculators choose variable-spread packages, because they give access to the cheapest spreads available in the market at any time. In the end, whether to use fixed or variable spreads comes down to personal choice.
How is the spread calculated in currency trading?
First, the cash value of the spread depends mainly on the size of the contract you trade, because that lets you determine the size of each pip. In forex, to calculate the pip value in the quote currency (the second currency listed in the pair), you multiply 0.0001 by the contract size. For example, trading one contract of GBP/USD (100,000 units of pounds sterling) gives a pip value of US$10 (100,000 × 0.0001 in the second listed currency).
Perhaps the easiest way to look at this is that, for all currency pairs except those using the Japanese yen, a contract size of one standard lot gives a pip value of 10 units of the quote currency. For pairs quoted in Japanese yen, the pip is the second digit after the decimal point, which means the calculation above would use 0.01 instead of 0.0001.
Finally, when trading forex with technical indicators, it’s usually a good idea to use additional indicators to confirm the signals your main indicator provides. For traders who enter the market frequently, a spread indicator can be used as a final filter before entering, to make sure you are not entering at a bad time for spreads.
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Frequently asked questions
Why does the spread change?
The main reason the spread changes is a change in the gap between the price at which financial instruments are sold and the price at which they are bought. This happens when the price of the instruments moves.
What is XM’s spread?
XM offers spreads starting from 0.0 pips and reaching up to 1.6 pips at times.
When does the spread rise?
The spread usually widens when trading starts in a new session and the market opens, because low liquidity increases the size of the spread. As markets begin to see liquidity flow in, the spread starts to settle.
What is the spread in trading?
The spread is the difference between the price at which financial instruments are sold and the price at which they are bought. It’s the amount most trading firms charge for opening positions.
Read more:
Trading in the currency market and how speculation works
The best currency trading strategy and steps to profit
Related guides: Lowest-spread forex brokers, Forex account types.
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