XM does not provide services to residents of the United States of America.
“The spread is an inevitable part of trading, but with the right knowledge and strategies, you can minimise its impact.”
Some traders make the mistake of setting off on their forex journey without fully knowing the costs. For instance, you may think that your broker doesn’t charge you anything because they keep advertising the fact that they are commission-free. However, commission is not the only cost when it comes to forex trading. There is also the spread that needs to be taken into consideration.
That’s right. Few things in life come for free, and forex trading is not one of them. “But what is the spread and how large a cost does it incur?”, we hear you asking. So, before you lose patience with us, let’s dive into the main topic of our article: what forex spreads are and how you can keep track of them to manage their effect on your profits.
Jump to a Section
- What Is the Spread?
- How the Spread Affects Your Profits
- Calculating the Spread
- Types of Spreads
- What Affects Spreads?
- Calculating the Cost of Your Trade
- Managing Your Trading Costs
- Final Thoughts
What Is the Spread?
In forex trading, the spread is the difference between the bid price and the ask price of a currency pair. You may have already noticed it; when you view the price of a currency pair, the vendor quotes two different prices. The bid price shows the price at which your broker is willing to buy the currency pair from you. The ask price shows the price at which your broker is willing to sell the currency pair to you.
The spread is the difference between the two prices.
How the Spread Affects Your Profits
You will have noticed that the ask price is higher than the bid price. This means that your broker is buying a currency pair from you at a lower price than it is selling it to you.
If we take the example from the image above, we can easily deduce how the spread can affect your profit. Let us assume that you opened a position and bought 1 Euro at the price of 1.0860 US dollars, ie., the ask price quoted above. If you were to immediately close that position before there was any fluctuation in the exchange rate, your broker would have bought it back from you at the price of 1.0858 US dollars, ie., the bid price quoted above. The difference of 0.0002 US dollars, that is to say the spread, would be your loss.
This means that every time you open a trade, the market needs to move in your favour by at least the amount of the spread for you to break even. And the wider the spread between the bid and ask prices, the higher the cost you pay for the execution of your trades.
Over time, this can have a significant impact on the profits you make. For instance, some short-term strategies like scalping can see their profits being greatly affected by the spread. This is because they rely on opening multiple positions to profit from minor price movements within a short period of time.
Calculating the Spread
The spread is calculated in pips, which is the smallest unit of price movement in a currency pair.
We calculate the spread by subtracting the bid price from the ask price. In other words, the formula is:
Spread = Ask Price – Bid Price
Going back to our previous example, if we are trading EUR/USD at 1.0858/1.0860, the spread would be calculated as follows:
Spread = 1.0860-1.0858 = 0.0002 = 2 pips
Types of Spreads
There are mainly two types of spreads in forex trading.
1. Fixed Spreads
As the name suggests, fixed spreads remain constant regardless of market conditions. They are usually offered by market maker brokers, and they make transaction costs predictable for traders.
However, they can bring about situations, especially in times of volatility, where the broker is unable to open a position due to not being able to widen the spread to adjust for the changing market conditions. Such situations are called “requotes”. Your broker basically rejects your trade and asks you to accept a new price to open your position.
Slippages can also commonly occur when the spreads are fixed. These refer to the times when a broker opens your position at a different price than the expected one.
2. Variable Spreads
Variable spreads, on the other hand, fluctuate and change according to the changing market conditions. They are usually offered by non-dealing desk brokers who get their pricing from a variety of liquidity providers.
They are tight during times of high liquidity but grow wide during unstable and volatile markets. While variable spreads can be lower than fixed spreads when the markets are calm, they can be wider during times of significant market movement. However, they do not lead to requotes or slippages.
At XM, despite being a market maker broker, we offer you variable spreads. This is how we eliminate requotes and slippages, and offer you competitive rates with transparent pricing.
What Affects Spreads?
Market Conditions
As we touched upon earlier, spreads are affected by market conditions. For instance, during periods of high volatility, they can be wider than expected. Conversely, during periods of calm and high liquidity, they tighten. This is due to the changes in the supply and demand of currencies. If there is a higher demand than supply for a currency, the value of the spread will be larger.
Currency Pair
How wide or tight the spread is will also depend on the currency pair you trade. For instance, major pairs like EUR/USD or USD/JPY have tighter spreads than exotic pairs like USD/TRY and USD/ZAR. This is because exotic pairs are more volatile and less liquid than major pairs.
Trading Times
Your time of trading will also have an impact on the spreads of your trades. Let’s say you want to trade GBP/USD. This currency pair is more liquid during the overlap of the London and New York trading sessions. The spreads will therefore be tighter then. Another example is that currency pairs can become extremely volatile during news releases. If you do not want to be dealing with large spreads, then this is a time to avoid trading.
Calculating the Cost of Your Trade
To calculate the overall cost of your trade, work out the amount of the spread you will be charged by subtracting the bid price from the ask price, then multiply it by your trade size.
For instance, let us assume once again that the bid and ask prices for the EUR/USD are as follows:
| Bid Price | Ask Price |
|---|---|
| 1.0858 | 1.0860 |
The spread, which we had worked out before, is 0.0002, ie. 2 pips.
Now assume that you will be trading 1 micro lot, which is 1,000 US dollars. You will therefore be paying the transaction cost of 2 pips 1,000 times:
1,000 x $0.0002 = $0.2
In this case, 0.2 US dollars will be the overall cost of your trade.
Managing Your Trading Costs
Here are a few tips for managing and minimising the impact of spreads on your trading:
1. Choose the Right Broker: Select a broker that offers competitive spreads and fits your trading style. Brokers with lower spreads can help reduce your trading costs.
2. Trade During Peak Hours: Forex spreads tend to be narrower during the most active trading hours, such as the overlapping periods of major trading sessions (e.g., London and New York). Trading during these times can help you take advantage of tighter spreads.
3. Monitor Market Conditions: Be aware of market conditions and avoid trading during times of high volatility or low liquidity, such as news releases, as spreads can widen significantly during these periods.
Final Thoughts
Understanding the spread and how it affects your forex trading is fundamental to your success. By choosing the right broker, trading during optimal times, and being mindful of market conditions, you can manage spread costs effectively and enhance your profitability. Remember, the spread is an inevitable part of trading, but with the right knowledge and strategies, you can minimise its impact and maximise your trading potential.
Ready to Start Trading?
Access a wide range of assets with a global broker by your side. Buy and sell currencies, stocks, indices, commodities and much more on our user-friendly and innovative platforms.
Frequently Asked Questions
1. What is a good spread in forex trading?
A good spread typically refers to a low spread, which means the difference between the bid and ask price is minimal. It generally ranges from zero to five pips depending on the currency pair you are trading and the market conditions.
At XM, we offer variable spreads that can go as low as 0.6 pips depending on the account type you choose.
2. How can I avoid the spread when trading forex?
It’s not possible to entirely avoid the spread when trading forex, as the spread represents the broker’s fee for executing the trade. However, there are strategies you can use to minimise its impact on your trading costs. For instance, you can make sure that you trade during periods when the market is liquid and avoid trading during periods of extreme volatility.
You can also check the account options of your broker to see if they offer a zero-spread account. These account types usually charge commission, but they offer ultra-low spreads that approach 0 pips.
Read More
Forex Trading Sessions and the Best Times to Trade
