Understanding Forex Spreads: What Every Trader Should Know

Introduction

What is spread in forex? A spread refers to the difference between the bid price, representing the price at which the broker is willing to buy, and the ask price, representing the price at which the broker is willing to sell, of a currency pair.

Spreads can be narrow or wide depending on the pair traded, economic conditions, trading session, etc. Knowing how spreads work is vital because they have a direct impact on your trading costs and potential earnings in the forex market.

Highlights and Key Takeaways

• There are different types of spreads, including fixed, variable, and commission-based spreads. 

• Some of the strategies that manage spreads are swing trading, scalping, and long-term trading. 

• Position-sizing, stop-loss, and take-profit orders can help manage risks associated with live forex spreads. 

Types of Forex Spreads

Fixed Spreads

Fixed spreads remain the same in all market conditions. The spread is usually computed in the smallest unit of the price change of a currency pair. The exact computation method may vary among brokers. Let’s say that a broker is providing a fixed spread of 2 pips (pips stand for “percentage in point”) for the EUR/USD pair. A fixed spread is usually no more than 5 pips for most brokers. The spread will not change whether the market is quiet or volatile. 

• One of the advantages of fixed spreads is that they provide price certainty and transparency. As a trader, you’ll always know what to expect to pay when trading.

• You can also accurately predict how much you will spend on each trade.

• However, fixed spreads may result in higher costs in normal/quiet market conditions, and some brokers may provide unduly wide fixed spreads.

• Another problem is that fixed spreads do not adjust to market conditions. This makes them unsuitable for news trading. Based on statistics, you have higher chances of losing money by news trading. Moreover, they may fail to mirror the real interbank pricing, especially during highly volatile periods.

• Scalpers who open and close trades quickly often prefer to work with fixed spreads. The predictable nature of related costs enables them to manage their profit margins more effectively.  

Variable (Floating) Spreads

As the name implies, variable spreads change every now and then depending on market conditions, reflecting true interbank pricing. Spreads typically widen during economic data releases or when the market is highly volatile. For example, the spread on a EUR/USD pair may widen to 20 pips when the U.S. jobless claims report is released.

• Variable spreads may have lower trading costs than fixed spreads, especially when the market is calm. This is because variable spreads tend to widen during the release of economic data such as CPI, GDP growth, or raising or lowering interest rates, compared to fixed spreads.

• The other advantage of variable spreads is that they are ideal for long-term time frames. And if you are a swing trader with a large account balance, you will benefit from these spreads.

• One of the setbacks of variable spreads is that they are unpredictable in highly volatile market conditions.

• Variable spreads are not suitable for scalpers. Widened spreads can erode your profits, making it harder for you to make frequent profits from small trades.

Commission-Based Spreads

Commission-based spreads usually demand a separate commission fee on trades in addition to the usual ask/bid spread. Some brokers charge you a commission on every trade you make instead of widening spreads.

• The best thing about commission-based pricing is that it provides transparency, as you are always aware of the costs you will be charged. 

• However, remember to consider both the commission and spread costs. This will give you a more holistic view of trading expenses.

Factors Influencing Forex Spreads

Market Liquidity and Volatility

Currency pairs easily bought and sold in the forex market may have narrower spreads. A good example is the EUR/USD, which has a high trading volume. Market makers and liquidity providers offer narrower spreads in high-volume markets to remain competitive. 

• In contrast, a less liquid or exotic currency pair like the USD/THD may have wider spreads due to fewer market participants. Therefore, they are less competitive, and brokers are often not incentivized to provide narrow spreads.

• Spreads can become wider when there is high volatility in the market. You may notice this change, particularly during major economic announcements, geopolitical events, etc.

Time of Day

Forex spreads can differ from one trading session to another. For instance, when major trading sessions like the European and U.S. sessions overlap, the spreads may narrow. This can be attributed to increased liquidity, so you have a chance to optimize your trades. 

• Reduced trading activity in the Asian session may cause spreads on major pairs like the AUD/USD to widen.

• Consequently, market makers widen spreads to reduce risk and compensate for the reduced liquidity.

Calculating Forex Spreads

Understanding Pips and the Bid-Ask Spread

Short for percentage in point, a pip typically represents a digit in change in price at the fourth decimal place. A pipette is the smallest price movement in a currency pair and often stands as a change in price at the fifth decimal place, equalling a tenth of a pip. For most pairs, a pip is equivalent to 1/100 of 1% or 0.0001. For instance, if the price of the EUR/USD changes from 1.1055 to 1.1056, the 0.0001 rise in price is 1 pip. From this example, a pip is the fourth decimal place of a price quote.

• Notably, some currency pairs, like the Japanese Yen pairs, go out to two decimal places (e.g., 0.01).

• A bid price represents the highest price a buyer is willing to pay for a currency, while an ask price is the lowest price a seller is ready to sell a currency.

• The difference between these two prices is known as the bid-ask spread.

Total Transaction Cost

When computing the total transaction of a trade, remember to incorporate the cost of the spread and any related commissions because these costs directly affect your profitability. Let’s say you open a trade with 100 units of the EUR/USD pair where the spread is 2 pips (or 0.0002), and the broker charges a $5 commission per trade.

• The total transaction cost is equal to the spread plus the commission fee.

• Using our example, the total spread cost = spread (0.0002) x transaction size (100).

• This means that you will incur a spread cost of $0.02. When you add it to the commission ($5), the total trade cost for your transaction will be equivalent to $5.02.

Broker Selection

One of the factors that you need to consider when selecting a broker is regulatory compliance. This ensures the broker follows the set industry rules and your investment is safe with them. Also, choose a broker who offers user-friendly trading platforms and a broad range of currency pairs. The customer support should be top-notch, so you get help whenever needed.

• ECN/STP brokers and market makers play a vital role in the market, but their modus operandi differ.

• For instance, market makers typically help to create a market for the buying and selling of currencies by acting as counterparties to traders.

• In contrast, ECN/STP brokers link traders to a network of liquidity providers.

• As you select a broker, find out what kinds of spreads and pricing models they offer. This is because different brokers use different ways to set and manage spreads. As a result, you’ll know the expected trading expenses and how your trading strategy will be affected.   

Strategies for Managing Spreads

You can manage forex spreads through scalping. This mainly entails initiating many trades to make profits from small price movements. So, you are able to use low spreads and high liquidity pairs for quick trades. However, most brokers will charge a commission fee on each trade, which affects the profitability of the trading overall.

• Applying swing trading can also be helpful. This is where you focus on longer-time price movements that can stand wider spreads. Swing trading results in fewer trades and commission fees, which can affect profitability.

• Try engaging in long-term trading as well. By holding positions for an extended period of time (weeks, months, or years), you can limit the impact of spreads and commission fees on your general investment performance. Nonetheless, don’t overlook the overall trading costs.

Risk Management and Forex Spreads

Spread fluctuations can lead to significant losses, but they can be avoided by using stop-loss orders. This will ensure your trade automatically closes when the currency reaches a predetermined level, minimizing losses from widening spreads. 

• Also, using a take-profit order will help lock in your profits and hence reduce the impact of spreads on your trades. While spreads can impact profitability, they don’t impact how and where you take profits.

• Remember to adjust your position sizes based on the spread cost. This ensures that spread-related expenses are proportional to your account size.

Emotional Risks

It’s easy to get carried away and make irrational decisions that lead to loss of money when you see spreads widen. The best thing to do in such cases is to remain calm and stick to a well-thought-out trading plan, no matter what.

• Exercise discipline and adhere to risk-management rules to avoid unnecessary loss.

• Consider using automated trading plans (robots), which are not affected by emotions. Robots can help in executing trades without emotional interference, but it’s important to note that they are not immune to losses or market unpredictability. They operate based on programmed algorithms that might not adapt well to sudden or unforeseen market changes.

Conclusion

Understanding and managing forex spreads is crucial for you as a trader because they impact your profitability in the long run. Therefore, employ risk management measures, such as position-sizing, take-profit, and stop-loss orders, and strategies, such as scalping, swing trading, and long-term trading, to help minimize your trading costs.

Also, to avoid losses, don’t let emotions get in the way of your trading. Take time to learn more about spreads, and practice what you have discovered. This will help you become proficient in dealing with spreads and attain long-term success in trading.  

FAQ

What Is a Forex Spread?

A forex spread is the difference between the ask and the bid price of a currency pair.

How Do Different Types of Forex Spreads Work?

Fixed spreads don’t change, regardless of the market condition, while variable spreads fluctuate in real time depending on market behavior. Commission-based spreads require a trader to pay a separate commission for every trade they make.

How Can I Calculate the Total Cost of a Forex Trade, Including Spreads?

To get the total cost of a forex trade, add the commission fee to the spread cost. 

How Can I Manage Forex Spreads When Using Different Trading Strategies? 

When scalping, select a broker who provides low spreads and initiates trades during high liquidity hours. If you are swing trading, use liquid assets, as they tend to have narrower spreads.

What Are the Risk Management Considerations Related to Forex Spreads?

Use stop-loss and take-profit orders to minimize losses and lock in profits for your investment, respectively, to help minimize the impact of spreads. Also, apply position sizing to ensure spread costs are proportional to your account size.