What is Spread in Forex Trading?
Before attempting to understand the fundamentals of spreads in forex trading, one must first cover all their bases and understand the process of forex trading itself.
When you take a closer look at the forex trade structure, you will observe that all trades conducted on the foreign exchange are done through intermediaries.
These intermediaries need to be remunerated for their services and that remuneration is usually done in the form of a forex spread.
In this article, we will go in great detail about forex spread trading, forex spread comparison, what they mean and how you can calculate them as well as strategies you can use to make them work to your advantage.
Understanding Forex Spread.
Seasoned traders are usually aware of the fact that spreads can be easily found in almost every market and the foreign exchange is no exception in that regard.
A forex spread depends heavily on the “ask” price and the “bid” price of a currency pair. Let us understand what these two terms mean.
“Bid” price refers to the selling value of the base currency and “ask” price is the value at which you can buy the base currency and when you calculate the difference between the two, you get a price that is known as the spread.
Interestingly, a forex spread also happens to be the main source of income for various brokers who offer commission-free services to their clients.
Brokers practice this as it is a smart way of making money because:
a. It is a great marketing gimmick that will attract many customers as everyone will be interested when they see the words “commission-free” on their broker’s advertisement campaign.
b. This service is guaranteed to make money for the broker in one way or another.
How Forex Spreads Work.
Forex spreads are predominantly measured in the smallest unit of the price movement of a currency pair known as a Pip (Percentage in Point).
In case of a significantly big spread, the difference between two price points is sure to be higher which means there is a condition of low liquidity and high volatility for the trader.
Let us consider a simple scenario where a laptop repair shop offers to buy your old laptop. Now if they want to be able to make a profit from this deal then they’d have to buy your laptop at a price that is higher than their reselling price.
So their best option is to buy it from you for $700 and sell it for $899 after refurbishing it.
This balance can be referred to as the spread in this scenario.
Spreads can also be categorized as high or low, in case the spread is high then the trader can assume that there is high volatility in the market or there is low liquidity in the market.
In case the spread is low, then the trader can assume that market volatility is low but liquidity is high.
Types Of Spreads In Forex.
You will find two types of spreads on the foreign exchange.
1. Fixed Spreads: As the name suggests, fixed spreads are always fixed and they don’t fluctuate with the market.
Fixed spreads are more suitable for beginners as they require smaller capitals and carry predictable transaction costs.
The only downsides of fixed spreads are that they are more prone to be exposed to slippage and can be requoted.
2. Variable Spreads: Unlike fixed spreads, variable spreads do not stay stagnated and they experience constant changes over time.
Variable spreads are more suitable for traders with a little more experience with forex.
Variable spreads do not run the risk of slippage and they cannot be requoted as well.
How To Calculate Spreads.
Calculating a spread is an easy task.
To calculate a forex spread accurately, you will need two things. One is the value per Pip and the other is the number of lots that are trading.
For example, if a trader buys USD/EUR at 1.35640 and sells it for 1.35626, then the spread in pips would be 1.35626/1.35640 i.e 1.4 pips.
Furthermore, you can use this result to calculate the total cost of the trade by multiplying the pips you calculated with the number of lots that you are trading.
For example, if you were trading mini lots that contain 10,000 units and the value per pip were to be at $1, then your transaction cost would be $1.40 for this theoretical trade.
Traders should also keep in mind that your transaction costs will increase if your position size is also increased.
So if you were to be trading with 10 mini lots in the above example instead of just 1, then your transaction cost would come at $14 (Transaction cost per 1 mini lot times 10).
Traders often use forex spread comparison tools to determine the best options available to them. Many of them can be easily found online.
Forex Spread Trading In Your Favour.
There are mainly two ways in which you can use forex spreads to work in your favor while trading.
The first method is to stick to the most favorable hours for trading. This period is usually identified by the high volume of active buyers and sellers in the market.
Peak hour means peak trading activity in the market that will consequently increase the competition as well as the business demand.
Market makers will be sure to narrow their spreads so that they can be captured easily which is why it is important to make sure to identify the peak trading hours of different time zones.
The second method is to trade in popular currencies as much as you can and avoid the less traded ones.
The reason for this is that market makers will often prioritize the commonly traded currencies over the lesser traded ones.
What this means is that you won’t be able to find many market makers to accept your trade as they’ll be busy going after the popular currency pairs such as USD/JPY, GBP/USD, etc.