A forex spread is the difference between the bid (sell) price and the ask (buy) price of a currency pair, and it is essentially how a broker makes money without charging a commission on a transaction.
For beginner traders, it is important to understand how forex spreads work, how to calculate them and why they exist at all.
Here are some important questions to ask before you pick a broker:
How does one broker’s forex spread compare to another’s?
Does the spread seem reasonable or is it overly high?
If overly high, what does that say about the broker and the investment?
Does the spread indicate high or low risk?
Keep in mind, the spread will impact the cost of opening up any forex transaction.
But don’t worry, it is a lot easier to determine a spread than it seems.
How to calculate a forex spread
To calculate a forex spread, all you need to do is subtract both bid and ask prices of a currency pair and the result will be the spread.
Here are a few examples using popular currency pairs:
If you are trading the EUR/USD at 1.1051/1.1053, the spread is: 1.1053-1.1051=0.0002 or 2 pips.
If you are trading the EUR/GBP or bid price 1.1036/1.1039 ask price. The spread is 1.1039 - 1.1036 = 3 pips.
This calculation applies to all currency pairs, whether they are major, minor and exotic.
Remember that when you trade forex, you will be charged the entire spread when you open a trade and that is precisely the reason why trades always open in minus, because the spread was charged right at the opening.
Beware of Spreads
As mentioned above, traders who are just starting out need to consider the spreads that brokers offer, and do so closely.
Why? This ultimately will determine the cost you pay to trade foreign currency.
Brokers often offer commission-free trades as an incentive to attract customers onto their online trading platforms, which isn’t generally a bad thing, but they will build the cost of the transactions they conduct into their spreads.
Don’t be attracted too quickly by the offer of commission-free trades as then you can realise that a broker’s spreads are particularly high and you would have been better off with a commission.
Brokers have two main incentives for higher spreads.
It is how they make money.
It is how they protect against the risk of constantly fulfilling incoming buy and sell orders at market prices.
It is important to find a broker that offers the most competitive spreads. If the spreads being offered are unreasonably or unusually high, then pick one that offers something better.
There are plenty of brokers out there that have reasonable spreads.
83.45% of retail CFD accounts lose money. Trading on margin is high risk and is not suitable for everyone.
Dynamic - From 0.8 Pips
The Higher the Spread, the Higher the Cost
Despite it being a smart way for brokers to make money from transactions, a higher spread can also reflect how risky your investment is.
A spread is often determined by the currency being traded, how volatile it is, the liquidity and market factors.
Keep in mind that the wider the spread between the bid and ask price, the higher the risk inherent in the trade. Conversely, the tighter the spread, the lower the risk.
To offset the risk, and unexpected costs, you can consider the type of spread that works for you, and there are two kinds:
What is a fixed spread?
Fixed spreads generally stay the same and are offered by brokers that operate as a market maker or a dealing desk.
They have smaller capital requirements
They offer a cheaper alternative for traders with less money
They make it easier to calculate transaction costs
You have some certainty about cost of your trade
Frequent requotes, which are most often worse than the initial quote
Brokers block trades based on new rates
Slippage – the broker is unable to maintain quoted spread
What is a variable spread?
The spread is always changing based on market conditions and is offered by non-dealing desk brokers, who get their pricing of currency pairs from multiple liquidity providers.
Can reduce profit margin
Impacted by news
Profit can erode quickly
What affects spreads?
As we mentioned, external market factors can have a significant impact on forex spreads in either direction.
Here are a few to monitor:
Major economic indicators
Lack of liquidity
Suggestion for traders:
Watch the news closely
Have an updated forex economic calendar
Monitor economic data
Spread in Exotic vs. Major Pairs
Emerging market currency pairs generally have higher spreads compared to major currency pairs since they are less liquid and prone to greater political and economic uncertainty.
Conversely, major currency pairs – such as the EUR/USD or the EUR/GBP – have better spreads than exotic currencies, because they are considered more predictable investments in stable economies.
How do you determine the spread cost?
Just when you thought you understood how to determine a spread, there is another calculation you will need – that is the total cost of a spread.
Don’t be intimidated, it is only slightly more complicated than determining the spread itself.
Here it goes:
Spread in Pips x Lot Size = Spread cost
For example, if you are trading a mini lot of EUR/USD (10,000 units) and the cost incurred is of 0.0001 (1 pip per unit), the result will be $1.
As you embark on your forex trading journey, you will need to answer the questions mentioned at the top of this article.
This will prevent you from being overcharged by a broker, even if they are offering commission free trades, and provide some guidance against risky investment decisions.
Also, keep in mind that the higher the spread, the smaller the profit margin you will have for each unit that you are buying. Conversely, the tighter the spread the more money you can make off of your investment.
Alway remember that forex spreads are also impacted by market moving news, not just the broker’s incentive to profit off of a transaction.
Frequently Asked Questions
What is a Pip?
A Pip means the Point in Percentage.
Forex traders use Pip to define the smallest change in value between two currencies. This is represented by a single digit move in the fourth decimal place in a typical forex quote.
The bigger the spread, the bigger the Pip, then the higher the cost for the trader!
Why do spreads widen?
Spreads widen due to lack of liquidity and the last one happens due to major price swings, limit orders being removed and market participants not submitting market orders.
This causes market makers during their competitive battle for pricing to also widen their spreads to mitigate the risk of a loss while fulfilling orders.
What are typical spreads and how are they determined?
Spreads will vary from broker to broker depending on these factors but there are no typical spreads. Definitely ask your broker about the spread they use on currency transactions.
What is a foreign exchange rate?
It is the price of a domestic currency against another currency. It compares the value of one currency against the value of another. It is done so in pairs. These prices will change over time based on factors that affect currency prices.
Do spreads represent better execution?
While spreads can determine what broker you use, it doesn’t mean that they represent execution quality. It’s important to read reviews of the broker and test their system in order to judge their execution.