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In Forex trading, ‘spread’ refers to the difference between the buying (ask) and selling (bid) prices of a currency pair. It represents the cost of executing a trade and serves as compensation to the broker. This difference is measured in pips and is a crucial factor influencing trading costs and potential profits.
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Understanding Spreads Currency Trading
The process of purchasing and selling currencies at their current exchange rates in the hopes that the exchange rate would move in the investor’s favour is known as forex trading or FX trading.
- For example, traders can purchase euros for US dollars at the spot rate, which is the current exchange rate, and then sell the euros to close the deal.
- The trader’s profit or loss on the deal is the difference between the buy rate and the sell rate.
- It’s crucial to comprehend how currencies are quoted by FX brokers before delving into forex spreads on FX trading.
Constant and Variable Spreads
A spread can either be constant or variable, influencing trading expenses for investors.
Constant Spread
A constant spread remains consistent regardless of market conditions. This type of spread provides traders with predictability in their trading costs since the difference between the bid and ask prices remains steady over time.
Variable Spread
A variable spread fluctuates based on various factors such as market volatility, liquidity, economic news releases, and supply and demand dynamics. As the bid and ask prices for currency pairs change due to market conditions, the spread widens or narrows accordingly. During times of high market volatility or low liquidity, the spread tends to widen, making trading more expensive. In contrast, in periods of stability and high liquidity, the spread usually tightens, reducing trading costs.
Understanding and considering these variations in spread types is crucial for traders, as they directly impact the overall expenses incurred while executing trades in the Forex market. Traders often prefer tighter spreads as they can lower trading costs, particularly for short-term trading strategies where small price movements can significantly affect profitability.
Advantages and Disadvantages
The following lists some advantages and disadvantages of these two kinds of spreads:
| Fixed Spread | Variable Spread |
| Could face requotes | No risk of requotes |
| Predictable transaction costs | Can get a tighter spread than fixed |
| Smaller capital requirements | Can reveal market liquidity |
| More appropriate for novice traders | More appropriate for experienced traders |
| A volatile market won’t affect the spread | Spread can widen rapidly if there is high volatility |
| Likely to be exposed to slippage | Can be exposed to slippage |
Measuring Spread
The last decimal place on the price quote (equivalent to 0.0001) and pip, a tiny unit of change in the price of a currency pair, are used to measure the spread. Except for the Japanese Yen, where the pip represents the second decimal place (0.01), this is
true for most currency pairs.
- A larger spread indicates a bigger gap between the two prices, which typically translates into limited liquidity and high volatility.
- Conversely, a smaller spread denotes greater liquidity and less volatility.
- Trading a currency pair with a tighter spread will, therefore, result in a lower spread cost.
Calculating Spread in Forex
Within a price quote, the spread is computed using the most recent large numbers of the buy and sell prices.
- You pay the full spread upfront when trading forex or any other asset through a spread betting or CFD trading account.
- In contrast, when trading share CFDs, a commission is paid both when a trade is entered and exited.
- As a trader, you receive better value the tighter the spread is.
Example of Spread Trading
- For the GBP/USD currency pair, the ask price is 1.26749 and the bid price is 1.26739.
- Subtracting 1.26739 from 1.26749 results in 0.0001.
- Since the spread is determined by the price quote’s final large number, it equals 1.0.
What Determines the Spread in Forex?
Factors that can influence the forex spread include market volatility, which can cause fluctuation. For instance, significant economic indicators have the power to strengthen or weaken a currency pair, which in turn influences the spread. Currency pairs may gap or become less liquid in a volatile market, which will cause the spread to increase.
Watching our FX economic calendar will help you be ready for the potential for larger spreads. You can forecast whether currency pairs’ volatility will rise and, consequently, whether you’ll see a wider spread by keeping up to date on the events that could
make them less liquid. However, it can be hard to plan for unexpected economic data or breaking news.
Lower spreads are usually observed during the main forex market sessions, which take place in London, New York, and Sydney. The spread can be even more constrained when there is an overlap, such as when the London session is coming to an end, and the New York session is starting. The general supply and demand of currencies also affect the spread; if there is a strong demand for the euro, its value will rise.
Why Does the Spread Change in Forex?
When the difference between a currency pair’s buy and sell prices varies, the spread in forex also does. The term for this is a variable spread, which is the reverse of a fixed spread. You will always be working with a variable spread when trading forex.
In the event of a significant news announcement or an event that heightens market volatility, the forex spread may rise. One drawback of a variable spread is that you may lose money on your positions or be placed on a margin call if the spread widens significantly.
Conclusion
Comprehending and managing spreads is fundamental for success in the foreign exchange market. The spread, as the variance between buying and selling prices, serves as a minor but significant cost in executing trades. Recognising the distinctions between fixed and variable spreads, along with their respective advantages and disadvantages, is crucial for traders. Vigilance regarding economic indicators and market volatility is essential as they influence spread levels. Being mindful that spreads tend to narrow during active trading hours but can widen during volatile periods aids traders in making informed decisions. Constant awareness of spread fluctuations allows traders to adapt and strategize effectively in the dynamic forex landscape.