Spread in Forex Explained - Definition/Meaning & Examples
A spread in forex is the difference between the bid (sell) price and the ask (buy) price of a currency pair and essentially represents a broker's way of making money without charging a commission on a transaction.
It is important for new traders to understand how forex spreads work, how they are calculated and why they exist in the first place.
- Here are some important questions to ask yourself before choosing a broker:
- How does one broker's forex spread compare to another?
- Does the spread seem reasonable or is it excessive?
- If the forex spread is too high, what does that say about the broker and the investment?
- Does the spread indicate high or low risk?
But don't worry, determining a spread is a lot easier than it seems.
How to Calculate a Forex Spread
To calculate a forex spread, all you have to do is calculate the difference between the bid and ask price of a currency pair, and the result is the spread.
Spread in Forex explained
Here are a few examples of popular currency pairs:
If you trade the EUR/USD at 1.1339/1.1340, the spread is 1.1340 - 1.1338 = 0.0002, or 2 pips.
If you are trading the EUR/GBP or the bid 1.1036/1.1039 ask, the spread is 1.1039 - 1.1036 = 0.0003 or 3 pips.
This calculation applies to all currency pairs, regardless of whether they are major currencies (major), minor currencies (majors) or exotic currencies (exotics).
Remember that in forex trading you are charged the entire spread when you open a trade. This is exactly why a trade is always opened in the red, because the spread is calculated right at the opening.
Beware of spreads
As already mentioned, trading beginners must carefully examine the spreads offered by the brokers.
Why? This is ultimately decisive for the costs that you pay for foreign exchange trading or forex trading.
Brokers often offer commission-free deals as an incentive to attract clients to their online trading platforms, which is generally not a bad thing. But then they will often factor the cost of the transactions they make into the spreads.
So don't be tempted too quickly by the offer of commission-free trading - not that you then have to find out that a broker's spreads are particularly high and you would have been better off with a commission.
Broker's motives
Brokers have two main drivers for higher spreads:
This is how they make money
In this way, they protect themselves from the risk of constantly executing incoming buy and sell orders at market prices
It is important to find a broker that offers the cheapest spreads in comparison. If the spreads offered are unreasonable or abnormally high, you should choose a broker who will give you a better deal.
Of course, there is a good range of brokers that have reasonable spreads:
Featured forex brokers with low spreads
If spread is higher, The cost will be higher
While it's a smart way for brokers to make money on each trade, a higher spread can also show how risky your investment is.
A spread is often determined by the currency being traded, its volatility, liquidity and market factors.
The larger the spread (spread) between the bid and ask prices, the greater the risk involved in trading. Conversely, the narrower the spread, the lower the risk.
To balance risk and unexpected costs, you can choose the type of spread that works best for you. There are two types:
- fixer
- Variable
What is a fixed spread?
Fixed spreads usually remain the same and are offered by brokers who act as market makers or dealing desks.
Advantages:
- They have lower capital requirements
- They suggestion a cheaper substitute for traders with less money
- They make it easier to evaluate business prices
- You have some certainty about the cost of your trade
Disadvantages:
- Frequent subsequent listings (requotes), which are usually worse than the original listing (quote)
- Brokers block trades based on new prices
- The broker is unable to meet the specified spread (deviations)
What is a floating spread?
The spread is constantly changing depending on market conditions and is offered by brokers who are non-dealing-desk brokers and source their quotes for currency pairs from multiple liquidity providers.
Advantages:
- No requoting
- more transparency
- Better course design
Disadvantages:
- May reduce profit margin
- Influenced by news
- Profit can erode quickly
What affects spreads?
As before declared, exterior market aspects can have a important impact on forex spreads any way.
Here are certain to keep an judgment on:
- market volatility
- political uncertainty
- Breaking News
- Important economic indicators
- lack of liquidity
Suggestion for traders:
- Follow the news closely
- Follow a current Forex economic calendar
- Monitor current economic data
- Be informed
Spreads on exotics (Exotics) versus major currency pairs (Majors)
Emerging market currency pairs tend to have wider spreads than major currency pairs because they are less liquid and vulnerable to greater political and economic uncertainty.
Conversely, better known currency pairs - like EUR/USD or EUR/GBP - have cheaper spreads than exotic currency pairs as they are seen as more predictable investments in stable economies.
How to determine the spread and cost?
Just when you thought you figured out how to determine a spread, there's one more calculation you need -- the total cost of a spread.
Don't be intimidated, it's only slightly more complicated than determining the spread itself.
Here's how it works: Spread in pips x lot size = spread cost
For example, if you trade a mini lot of USD/EUR (10,000 units) and the cost is 0.0001 (1 pip per unit), the resulting amount is €1.
Conclusion
If you want to start your Forex trading journey, all you have to do is answer the questions mentioned in the introduction.
This will save you from being overcharged by a broker – even if they offer commission-free trades. This will protect you from risky investment decisions!
Also remember that the higher the spread, the lower the profit margin for each unit purchased. Conversely, the narrower the spread, the more money you can make from your investment.
And always keep in mind: Forex spreads are influenced by market-moving news – in the interest of the broker, but against the interest of your profit margin.
Much luck!
frequently asked Questions
What is a pip?
One pip equals one point in percent.
FX traders use pip to express the tiniest change in rate among two currencies. This is signified by a single figure movement in the fourth number place in a typical forex quote.
The bigger the spread, the bigger the pip and the higher the cost to the trader!
Why do spreads widen?
Spreads widen due to lack of liquidity, and the latter is happening due to larger price fluctuations, cancellation of limit orders and lack of market orders by market participants.
This causes market makers in their pricing competition to also widen their spreads to reduce the risk of loss when executing orders.
What are typical spreads and how are they determined?
Spreads vary from broker to broker depending on these factors: market volatility, political uncertainty, breaking news, key economic indicators, lack of liquidity. In general it can be said that no typical spreads exist. Be sure to check with your broker about the spreads they use for currency transactions.
What is a foreign exchange rate?
A foreign exchange rate is the rate of one domestic currency against another currency. It compares the value of one currency to the value of another. This happens in pairs. These rates change over time due to factors affecting currency prices, such as economic news.
Do spreads represent better execution?
While spreads can be a determining factor in which broker you choose, that doesn't mean they represent good execution quality. It is important to read broker reviews and testimonials and test their system to judge its execution.
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