“What is spread in forex,” “what does spread in forex mean,” and what is spread in forex trading” are among the questions that I receive with regards to forex spread.
To explain what does spread in forex mean, I will commence with a practical business example.
Picture any form of trading, such as purchasing clothes for resale or anything else that comes to mind.
The difference between the inceptive price and the amount of money received from the resale is referred to as profit or income.
Therefore, what is spread in forex?
A spread is like trade, and in this case, forex brokers are the ones who receive the income/profit involved.
For a better understanding of the forex spread and how it affects you, especially in trading, you need to first know the basic structure of any given forex trade.
One of the ways of checking the trade structure is by ensuring that all trades are carried out through middlemen who require you to pay for their services.
This middlemen’s charge (who are brokers in the case of forex), or the difference that emanates between the bidding price and the asking price for each trade, is referred to as the spread.
Forex brokers have two varying prices for currency pairs and that is the bid and ask price.
The “bid” represents the price at which you can SELL the base currency while the “ask” is the price at which you can BUY the base currency.
The difference between these two prices is referred to as the spread.
The base currency is the currency that comes first in a currency pair. For example, in a currency pair like EURUSD, the Euro is the base currency.
The spread is the way in which “zero commissions” brokers earn their money.
Other than charging a completely different fee for making a trade, the cost is included in the buy and sell price of the currency pair the trader wishes to trade.
Therefore once a broker demands “no commissions” or “zero commission,” it leaves a trader confused and is misleading more so to beginners in forex trading.
There is the question of how the broker makes money if they are charging zero commission.
You should note that even though there is no separate commission fee, you are still expected to pay a commission only that this commission comes in the form of spread.
Do you now have an idea of what is spread in forex?
How to Calculate Spread in Forex
The forex spread is normally brought out as a percentage, and can be calculated with the help of the formula below:
Spread = Ask (the price that a buyer is willing to pay) – Bid(the price where the market maker is willing to buy).
It is set in pips for suitable calculation.
The broker is the market maker in this case.
In an example, in case the quote of the GBPUSD currency pair:
bid = 1.1240 , ask = 1.1244,
Spread = 1.1244 – 1.1240 = 0.0004 USD which is equivalent to 4 pips.
You’re now familiar with what is spread in forex and how to calculate it. I can now move to the different types of spreads that exist in forex.
Types of Spreads in Forex
The types of spreads that are there on a forex trading platform are determined by the forex broker and how the broker makes money.
There exist two types of spreads, namely Fixed and Variable (floating) spreads.
Fixed spreads in forex are normally offered by brokers who work as a “dealing desk” model or market maker.
Fixed spreads remain the same no matter the market conditions that exist at any given time.
Whether the market is volatile or not, the spread does not get affected by the market.
It remains constant at all times.
Variable (floating) Spread
Variable spreads are given by brokers who work with a “non-dealing desk” model.
Just like the name suggests, variable spreads are not constant.
From the flexible spreads, the difference between the bid and ask prices of currency pairs change very often.
Some of the benefits and disadvantages of these two types of forex spreads are listed below:
|Fixed Spread||Variable (floating) Spread|
|Involves smaller capital requirements||Has the ability to reveal market liquidity|
|Not affected by a volatile market||High volatility results to widening of spread|
|Suits beginner forex traders well||Suitable for experienced traders|
|There is the probability of being exposed to slippage||Exposure to slippage is possible|
|Risks facing requotes||Risk of requotes is not prevalent|
|Transaction costs are predictable||Has the probability of attaining tighter spreads than fixed|
Factors that Affect the Forex Spread
I hope by now, you are not asking the question of what is spread in forex. It ought to be clear by now.
There are numerous factors that can impact the magnitude of bid/ask spreads that dominate specific trading floors.
Among them there is
Countries that go through unrestrained political environments or weak, unstable economies basically have their currencies being subjected to high risk.
These economies normally have really high inflation rates and have no disciplined approach to monetary policy.
The aspect results in the forex spread becoming larger than it would be in normal circumstances.
This happens because dealers will view the currency as a high-risk investment, and will therefore only sell the currency at a premium rate.
Buyers purpose and seek to purchase the risk at a discount to cover the higher risk involved.
The bid-ask spread therefore widens, and trade volumes thus experience a decrease.
Normally, higher trading volumes are a sign of a more liquid market, meaning a lower bid-ask spread.
A decrease of the foreign exchange spread results in the difference between dealer and buyer valuations of the currency.
Hence, dealers are able to find a buyer with a similar bid price to their ask price more easily and continue to engage in a trade.
Similarly, a buyer easily finds a dealer who willingly accepts their offer to purchase the currency for a given price.
Higher foreign exchange spreads basically show lower trading volumes because forex trade buyers and dealers experience more challenges getting a willing trade partner.
In case a currency lacks the support of a disciplined monetary policy and a stable central bank, it is normally more open to changes in value.
This then results in dealers pushing ask prices higher, which in turn pushes the bid-ask spread upward.
How to Minimize and Manage the Spread in Forex
There are two ways of reducing the cost of these spreads:
One way is to trade only during the best trading hours when the market is flooded with buyers and sellers.
While the number of buyers and sellers for a particular currency pair rises, demand and competition for the business are higher, and the brokers normally narrow their spreads to capture the inherent business.
Avoid selling and purchasing currencies that are thinly traded.
When you trade a thinly traded currency pair, there will most likely be only a few market makers who will agree to the trade.
Additionally, noting the reduced competition, they will keep a wider spread.
That is the information I will be giving today on what is spread in forex. I hope it is of help.