What is Spread in Forex trading?
The Forex Market is where traders get to trade and speculate on the prices of different currencies from different nations. Having seen substantial growth ever since its inception, Forex has attracted a lot of traders to itself from every corner of the world.
Forex traders should know and understand common terminologies such as Spread which could make or break their trades.
First of all, you should know that in spot trading, currencies are referred to in pairs.
XXX/YYY 1.2345
The currency on the left (X) is the base currency, the currency on the right (Y) is the quote currency, and the number 1.2345 represents the value of the base currency in comparison to the quote currency.
For instance, in the EUR/USD pair priced at 1.3500, Euro is the base currency which makes the dollar the quote currency. That is to say, to buy 1 euro a trader must pay 1.35 dollars. Moreover, no matter what currency is used as the base currency, it is always counted as 1.
During your trades, you will encounter two sets of prices in the Forex rate as illustrated below:
EUR/USD = 1.3500/1.3502
The number on the left represents the bid price or the price at which you sell your currency. The number on the right represents the ask price or the price you get when you buy the currency. As you can see, there is a small difference between these two currencies, that difference is called the Spread.
Ask Price 1.3502
Bid Price 1.3500
Spread 0.0002 (2 pips)
For example, the current exchange rate for EUR/USD is 1.3501. The Broker offers a deal like this 13500/1.3502. In other words, the bid and ask prices offered by the Broker for the EUR are 1.3500 USD and 1.3502 USD, respectively. In this particular trade, the spread for the EUR/USD pair is 0.0002, or simply 2 pips.
How does Spread work in trading?
Forex brokers charge the spread as the cost of transactions. Just like normal business transactions, brokers raise their prices by several points to make money.
For example, when the price of EUR/USD is 1.3500, brokers will open the market at 1.3500 / 1.3503. This means that the brokers will buy at the bid price of 1.3500 and sell at the ask price of 1.3503, resulting in an instant profit of 0.0003 or 3 pips straight into their pocket.
Forex brokers offer different spread amounts depending on their policies and conditions. Some brokers may offer spreads as low as 1-2 pips, but the catch is, they’d often require additional fees. And there are some that offer higher spreads without additional fees.
The spread amount can also be affected by the currency itself, meaning the more stable a Broker is, the lower the spreads and vice versa. As a rule of thumb, you’d want to choose a Forex broker with low spreads to reduce your trading costs.
Types of Spreads in Forex
When you open an account with a Forex broker, they will offer you two types of spread, namely fixed spread, and floating spread.
1. Fixed spread
As the name suggests, the amount of a fixed spread will not change; however, the spread will temporarily change to a new fixed level depending on the market volatility until the market returns to normal.
Fixed spreads are more convenient and beneficial for clients because they are predictable and less risky, but they are usually higher, i.e., 2-3 pips or more. Additionally, this type of spread is offered in a standard or micro Forex account.
2. Floating Spread
The value of the bid/ask price for a floating spread will constantly change based on the market. At the same time, it may be offered as low as 0.5 points or even 0 points. These quantities change frequently based on the fluctuations of the market.
If you trade using the short-term or Scalping trading method, then this type of spread might suit your purposes, because floating spreads are the lowest spreads in the market. Floating Spreads are generally provided by ECN Forex Brokers.
The importance of the Spread
You might think that the spread is a small amount and it does not matter based on the above example. So why is it so important?
The same calculation as in the example – 0.0002 or 2 pips, will add up per unit of currency traded. You may be just a small trader with small lot sizes, but for a professional trader with much larger lot sizes that makes a huge difference.
For example:
EUR/USD 1.3500/1.3502
Spread = 0.0002 or 2 pips/unit
If you are a small trader who wants to buy a currency of 10 standard lots (1,000,000 units) with the same spread amount, in that case, you have to pay a $200 spread (0.0002 x 1.000,000 = 200 USD) to the broker. That is why the spread is so important. To be a successful trader, you need to calculate spreads accurately and reduce spread costs as much as you can.
