What is Spread in Forex-How to calculate spread

If you’re new to the world of forex trading, you might have come across the term “spread” and wondered, “What does this mean?”

Don’t worry—you’re not alone! In forex trading, the spread is one of the most essential concepts to understand because it directly affects your profitability. Lucky for us, the concept of the spread is not as complicated as it might seem.

Let’s break it down together in this comprehensive guide, covering what spread is, how it works in forex with simple examples, the different types of spreads, and their pros and cons. By the end, you’ll feel much more confident about navigating spreads in the forex market.

What is Spread in Forex?

In simple terms, the spread in forex refers to the difference between the bid price (the price at which you can sell a currency pair) and the ask price (the price at which you can buy that same currency pair).

You’ve probably noticed that when you go to trade a currency pair, there are always two prices on the chart—one slightly higher than the other. That tiny difference? That’s the spread.

The spread essentially represents the cost of placing a trade. It’s how brokers make their money. Instead of charging a direct commission, many brokers factor their profit into the spread. It’s a small fee deducted automatically whenever we open a trade.

How Does Spread Work? [Simple Example]

Let’s take an example to really simplify things:

Imagine we’re trading the EUR/USD currency pair, and the prices are quoted as follows:

Bid Price: 1.1000 Ask Price: 1.1002

Here, the spread is the difference between the ask price (1.1002) and the bid price (1.1000), which is 0.0002, or 2 pips.

When we open a trade:

If we decide to buy at the ask price (1.1002), we immediately lose 2 pips because we could only sell it back at the lower bid price (1.1000) at that moment. To break even, the market price would need to rise by at least 2 pips so that the bid price matches or exceeds the ask price at which we bought.

So, the smaller the spread, the less we pay “upfront” when entering a trade.

Types of Spread in Forex

There are two main types of spreads in forex: fixed spreads and variable (or floating) spreads. Let’s take a closer look.

1. Fixed Spreads

As the name suggests, fixed spreads remain constant regardless of market conditions. Whether the market is volatile or calm, the spread stays the same.

Pros of Fixed Spreads:

Predictability: We always know what the spread cost will be. Ideal for Beginners: Fixed spreads are straightforward and easy to factor into your trading strategy.

Cons of Fixed Spreads:

Requotes: During highly volatile times, brokers using fixed spreads may delay our trades, resulting in requotes. Higher Costs in Stable Markets: In calm market conditions, fixed spreads can sometimes be higher compared to variable spreads.

2. Variable Spreads

Variable spreads fluctuate depending on market conditions such as volatility and liquidity. When the market is calm with high liquidity, the spread is usually very tight. However, during major news events or highly volatile times, spreads can widen significantly.

Pros of Variable Spreads:

Cost-Effective in Steady Markets: We can benefit from lower trading costs during calm conditions. Transparent Pricing: Variable spreads reflect actual market conditions.

Cons of Variable Spreads:

Unpredictable Costs: Spreads can widen during volatile periods, making it harder to estimate our expenses. Risk During News Events: If spreads spike dramatically, they can eat into profits or increase losses.

Factors That Affect Forex Spread

Several factors influence the size of the spread, so it’s important for us to stay aware of these when trading:

Market Volatility: Higher volatility often leads to wider spreads.

Liquidity: Currency pairs with lower liquidity (think exotic pairs) tend to have wider spreads than major pairs like EUR/USD or GBP/USD.

Broker Type: Different brokers offer different pricing models. ECN/STP brokers typically have tighter spreads compared to market makers.

Time of Day: Spreads can be tighter during major trading sessions, such as when the London and New York sessions overlap.

Pros & Cons of Spreads in Forex

To help us weigh the impact of spreads on our trading, let’s recap their pros and cons.

Pros

No Visible Commissions: Many brokers incorporate their fees into the spread, simplifying costs for most traders.

Accessible to Beginners: Spreads are straightforward to understand and consider in trade calculations.

Variety of Options: We get to choose between brokers offering fixed or variable spreads as per our trading style.

Cons

Increased Costs During Volatility: In volatile markets, spreads can widen substantially, leading to higher trading costs.

Impact on Scalping or Day Trading: If spreads are too wide, they can significantly hurt short-term trading strategies.

Hidden Costs: While spreads eliminate the need for separate commissions, they can still represent a sizeable trading expense if not monitored.

FAQs About Spread in Forex

Q1: Why is the spread important in forex trading?

A: The spread directly affects your trading costs and profitability. Narrower spreads mean lower costs, which is especially important for traders who open and close multiple positions each day.

Q2: Can I calculate the exact spread cost?

A: Yes, the cost of the spread can be calculated by multiplying the spread (in pips) by the position size. For example, if the spread is 2 pips and you’re trading 1 standard lot (100,000 units), the cost would be $20 in a USD-based currency pair.

Q3: How can I reduce the impact of spreads?

A:

Trading during major market sessions can help minimize spreads. Stick to major pairs with higher liquidity and tighter spreads. Consider using ECN brokers with variable spreads if you’re trading in calm markets.

Q4: What’s the difference between spread and commission?

A: Spread is an indirect trading cost built into the buy and sell price of a currency pair, while a commission is a direct fee charged by some brokers on every trade.

Tips for Managing Spreads Effectively

Here are some actionable tips to navigate spreads like a pro:

Use a Reliable Broker: Choose a broker that offers competitive spreads. Read reviews and test their spreads on a demo account first.

Monitor Economic News: Be cautious around major news releases as spreads often widen during these times.

Understand Your Strategy: If you’re a scalper, prioritize brokers with very low spreads. If you trade long-term, the impact of spreads is less pronounced.

Stick to Liquid Pairs: Major currency pairs like EUR/USD, GBP/USD, and USD/JPY usually have the tightest spreads.

Conclusion

Spreads might seem like a small detail in forex trading, but they play a vital role in determining our trading costs and overall profitability.

Whether we’re trading with fixed or variable spreads, understanding how they work and how they affect our trades is key to developing a successful strategy.

By choosing a reliable broker, planning our trades wisely, and factoring in the spread’s cost, we can minimize its impact and focus on achieving consistent results in the forex market.

Now that we’ve demystified spreads together, let’s put that knowledge into practice and sharpen our forex trading skills!

Happy Trading! ????