A spread in forex trading is something that you may come across. You may find that a lot of forex brokers talk about forex spreads.
Even when you look around to various trading forums, you will find traders discussing about the spreads on the different currency pairs. So what exactly is a spread in forex trading and why is forex spread so important?
If you are a beginner to forex trading, this article explains to you what is a forex spread and why it is so important. In your trading journey, understanding the meaning of a forex spread is the most fundamental.
Without knowing the meaning of spread in forex, you will not succeed even if you use the best forex trading strategy.
However, this article will explain to you the definition of a forex spread, how the forex spread is constructed and how you can understand and calculate the forex spread by yourself.
What is the meaning of spread in finance and trading?
A spread is nothing but the difference between two prices belonging to the same asset.
A simple way to explain this is with an example. Let’s say that you bought a new Apple iPad at a cost of $600. A few months later you decide to sell your Apple iPad. You already know that you would not be getting the same price that you paid the Apple iPad for. Therefore, you might sell your Apple iPad at a price of $550.
As you can see in this example, you bought the iPad at $600 and you sold the same iPad at $550. The difference between the price at which you bought and which you sold is called the spread. In our example this is -$50.
Let’s take the same example and look at it in a different way.
You purchased the Apple iPad for $600. A few months later you learn that your iPad model will no longer be manufactured. This makes the iPad model rather unique, and you see a lot of demand as a result.
Now you can sell your iPad for a cost of $700.00. In this example, your spread is the difference at the price you bought the iPad and the price at which you sold. Here, the spread is $100.
Applying the same example to the financial markets, spread is defined as the difference between the price at which an asset was bought and sold.
What is the spread in forex?
A spread in forex is the difference between the bid price and the ask price. Now you might wonder what the bid price is and the ask price.
The bid price is the price at which you can buy a forex currency pair. The ask price is the price at which you can sell the same forex currency pair.
If you closely observe your forex brokers Market Watch window, you will see two prices displayed.
These two prices are nothing but the bid and the ask price for the currency pair in question.
If you want to buy the currency pair, then you would be buying at the ask price similarly, if you want to sell a currency pair you would be selling at the bid price.
It is important for traders to know that the bid price is the price at which you can sell and the ask price is the price at which you can buy.
In the above chart, you can see that the EURUSD has a bid price of 1.18651.
This is the price at which you can sell or go short on the EURUSD in the market. Similarly, the ask price for the euro USD is at 1.18664. This is the price at which you can buy in the market.
The difference between the bid price and the ask price which in this case amounts to 0.00013 is called the spread.
In trading terms, this would translate to 1.3 pips.
In forex, a pip is the minimum change in the price of an exchange rate. It is the 4th decimal in the exchange rate. 1000 pips equal to one cent.
Why do spreads exist in the forex market?
As you may know, in the forex markets, you are buying and selling the currency pairs. This means that there needs to be a counterparty from whom you can buy or sell the currency pair.
Depending on the type of forex broker that you are trading with, the counterparty may be the forex broker themselves or someone within the liquidity pool.
A forex broker who becomes the counterparty to your trade is called a dealing desk broker or a market maker. A forex broker who does not take a counter position to your trade is called a non dealing desk forex broker. You can read more about the different types of forex brokers here.
Spreads not only exist in the forex market, but you can find them in just about any financial market that you want to trade.
In the stock markets for example, you will often find that the spread for a stock will often be a few cents off from the bid and the ask price is. Similarly, if you look to the futures market, the futures prices will also carry different bid and ask prices.
Buying low and selling high – The concept of spreads
Spreads exist in the forex market because someone has to make money for taking on the risk of buying and selling a currency pair. In most cases, spreads are either applied by the liquidity provider or the spread is applied by the forex broker themselves.
The spread in the forex market is one of the ways for a forex broker to make money. As you notice in the previous picture, the bid price is always higher than the ask price. This runs contrary to the philosophy of buying low and selling high.
In fact, if we go back to our example of the bid and ask price, you are actually selling at a lower price and buying at a higher price.
But if you flip this over, from the counterparty’s perspective, they are buying low and selling high.
Going back to our example of the Apple iPad, if you purchased the iPad from someone else at a cost of $700.00 whereas they bought it at a price of $600, you are essentially paying them the spread of $100. This is the profit that your counterparty has made.
Depending on how high the demand is for the Apple iPad, you can continue to do this as well. In other words, if you purchase the iPad at $700.00, you can try to sell it for $800 and make a $100 profit for yourself.
How does a forex spread impact your trading costs?
So far, we have established that a spread is nothing but the difference between the bid and the ask price. You already know that you are paying extra money when there is a spread involved. But this is the cost of doing the transaction.
This very spread can however impact your cost as a forex trader.
Going back to our original example of the EURUSD spread, let’s assume that you want to take a long position.
The price at which you can buy the EURUSD is 1.18664. In order for you to break even, you will have to wait for the bid price to move to 1.18664. This is about 1.3 pips movement.
If you want to open a EURUSD position with one lot, the cost is $13.
The below table shows a calculation of one pip based on different lot sizes for EURUSD.
Therefore, in terms of money paid to your forex broker, the spread costs you as little as $0.10 or as high as $10.00.
Forex spreads – Floating vs. Fixed Spreads
You may have come across forex brokers who advertise that they offer fixed spreads or floating spreads. This depends again on the type of forex broker you are dealing with. Typically, a non dealing desk forex broker would offer you floating spreads whereas a market maker would offer you fixed spreads.
Before we go into further details, we need to understand why the spreads can change. You already know by now that a spread is nothing but the difference between the bid and ask prices.
Depending on the trading volume, the spreads can be very tight or low or they can be very high or large. Traders usually look at the spread in order to understand how liquid a financial instrument is.
Take a look at the picture below which shows the difference in the spread between EURUSD which is a major currency pair and the USDTRY which is a minor currency pair.
The difference in the spread between these two currency pairs tells you how liquid one currency pair is from the other.
Clearly, the USDTRY spread is way higher than the euro USD spread. This is because of the fact that the USDTRY is an exotic currency pair or also known as a minor currency pair. It is not that popular for trading and hence the spreads are a lot higher.
Spreads can also change depending on the rise and fall in trading volumes. As a result, the general market convention is to either make use of a fixed spread forex broker or a floating spread forex broker.
What is a fixed spread?
A fixed spread as the name suggests offers a fixed spread regardless of the market conditions.
The benefit of trading with fixed spread is that no matter what time of the day, the forex spread in the currency pair will remain constant. This has significant advantages as well as disadvantages.
One of the major complaints of using a fixed spread is the fact that when you are trading around a volatile news event, you will not be able to place your trades. This is because depending on how the market reacts, the spreads can be higher or lower than the fixed spread you are already being charged.
This is one of the reasons why some forex brokers who act as market makers do not allow news trading.
What is floating spread?
A floating spread as the name suggests is where the spread keeps changing depending on the changes in liquidity and trading volume.
This means, for the same currency pair, you may find that the spreads are much higher at certain times of the day while the spreads are much lower during other times of the day.
A floating spread is more beneficial if you want to trade during the market hours. This is when trading volume and liquidity picks up and hence the spreads are very low. On the other hand, it would be disadvantages to you if you want to trade using a floating spread during off market hours.
When using floating spreads, you will also see that the spreads can either increase or decrease especially during major news events.
Which is better a fixed spread or a floating spread?
now we come to asking the obvious question as to which type of forex spread is better. Is it beneficial to you as a trader to make use of a fixed spread or to make use of a floating spread.
The answer to this basically depends on what you want to do in the forex markets. As you already know, dealing desk forex brokers usually have a fixed spread. On the other hand, ECN or STP forex brokers have floating spreads.
There are both advantages and disadvantages with dealing with fixed and floating spreads. One of the biggest issues with floating spreads is the fact that if the spreads widened too much, then depending on your capital it may trigger a margin call.
A very good example of this can be found in the case study of the EURCHF currency pair. It was in January 2015 when the Swiss National Bank surprised the markets by announcing that it was removing the CHF peg to the EUR.
The sudden lack of liquidity in the market below the peg saw many forex brokers going out of business. It also put many forex traders into debt with their forex brokers.
On the other hand, traders who were trading with a fixed spread forex broker were in a much better position as there was virtually no impact on them.
This is especially true if you are trading exotic currency pairs with floating spreads.
To conclude, a forex spread is something that you cannot avoid as a forex trader. However, what is in your control is the choice to choose between a fixed spread or a floating spread forex broker.
If you are just starting out in forex trading, then it is advisable that he chose to trade with a fixed spread forex broker.