What is spread in forex trading?
Spread is, in simple terms, a sort of commission that brokers and specialists are able to collect on every forex trade. This commission is passed on to you, the trader, where it translates into the difference between the bid (sell) price and the ask (buy) price of a given currency pair.
Different brokers offer different spreads for different services, meaning that the choices you make could have a significant impact on your bottom line. With that in mind, read this essential beginner’s guide to spread in forex trading.
Spread is a term that is not unique to forex trading, but it is definitely the market where the term is the most important to know. In simple terms, spread is the difference between the current buy and sell prices of a given currency pair on the market.
Traders will pay a certain price to buy a currency and, according to the spread, they would instantly lose money if they were to try and immediately sell that same currency pair back to the broker. This is because the spread was added to the buy price as a form of commission, meaning that the trader paid more to buy the currency.
The broker sold the currency to you for more than they paid for it, pocketing the difference (spread) as a form of profit. This is how so-called “commission-free” brokers actually make their money. The buy price being quoted is always going to be lower than the sell price, with the actual market price lying somewhere in between the two.
Spread is usually very small, usually just a few pips, or a fraction of a percentage of the currency unit. However, when making large investments into currency pairs this can quickly add up to significant costs for traders and significant profits for brokers. That is why it is essential to properly calculate spreads before you commit to any type of forex transaction whatsoever.
Bid price explained
In any form of financial market transaction, the bid price is the amount that a buyer is willing to pay for an asset. It is the “buy” price from the perspective of the forex broker. When discussing bid and ask prices, remember that you are the price “taker”.
Therefore, when we say that the bid price is the “buy” price, we mean that it is the price at which the broker is willing to buy forex from you. It is, therefore, the price at which you can expect to sell your own currency.
The broker is the price maker, or “market maker” in all forex transactions. The bid price will always be lower than the ask price, since the broker will always sell currency to you for a higher price than they are willing to buy it back, if we are assuming that the underlying market price does not change at all. This transaction cost represents the spread.
Ask price explained
As we have mentioned, bid and ask prices assume that the price “taker” is you, the trader, and that the trade is done from the perspective of the broker. Therefore, the ask price determines the price at which the forex broker is willing to sell you the base currency in a given forex pair.
It is, in this way, the opposite of the bid (buy) price. The ask price will always be higher than the bid price, as this is how brokers and intermediaries make their money. For example, let’s say that GBP/EUR is trading at 1.1038. The bid price listed by the broker in this scenario might be 1.1037, which is one pip lower than the underlying market price.
Conversely, the ask price would be higher, perhaps 1.1038, or one pip higher than the underlying market price and two pips higher than the bid price. This difference is the spread, or the commission that the broker takes for facilitating the trade on the global financial marketplace.
Since spread directly relates to the transaction cost of every trade that you make, it is useful to learn how to calculate spreads, so that you can determine the actual cash amount that you are spending on each and every trade. All spreads can be calculated by looking at the per-pip value of a trade and the number of lots that you are trading. Let’s walk through an example.
Let’s say the current buy price of EUR/USD is 1.3404 and that the sell price is 1.3398, meaning that the spread is 0.6 pips. The cost of this spread depends on the numbers of lots of EUR/USD you are trading.
If you’re trading a standard 100,000 unit lot, then the spread cost would be 0.6 pips x 100,000 lots, meaning that the cost of the transaction for you = $6.
Different types of spreads
There are two key different types of spreads that you need to know about, each of which will have a significant impact on your trading costs and your bottom line. These are fixed spreads and variable spreads. Read on to learn more.
A fixed spread is, as the name suggests, a spread that does not change, regardless of market conditions. Spreads are typically calculated on a regular basis according to market volatility, liquidity, demand and supply, and a host of other market factors. With a fixed spread, you are guaranteed to enjoy the same fixed rate for your trades. The broker is able to control their prices and offer a set spread to all traders that they work with.
The advantages with a fixed spread
As you might have guessed, the main advantage of fixed spreads is their predictability. You will know exactly what you can expect to pay for each transaction on any given day, without any surprise fluctuations. Fixed spreads usually tend to have smaller capital outlay requirements, making them better suited to traders that might not have a large amount of cash to invest.
The disadvantage of trading with a fixed spread
That being said, there are some disadvantages to using fixed spreads when trading forex. Since the broker can sometimes be “locked in” to a fixed spread during conditions of volatility or illiquidity, they might respond by hitting you with a “requote”. This is when the broker adjusts the price to accommodate these new conditions and will force you to go back and accept their new price, which will nearly always be lower than the original price.
Variable spreads are essentially the polar opposites of fixed spreads. They are spreads in which both the bid price and the ask price are constantly changing according to the market conditions. Variable spreads are imposed when a broker is not a market maker and gets all of their liquidity from various providers. This means that they have no control over their prices and that these prices are constantly subject to change.
The advantages of trading with a variable spread
A key advantage of variable spreads is that it can often (but not always) lead to better, more competitive pricing, as the price is dictated by myriad market factors. In addition, you will not experience requoting, which can be a relief.
The disadvantage of trading with a variable spread
That being said, a key disadvantage of variable spreads is that you can end up entering a trade at a completely different spread than you thought. In just a fraction of a second, your spread could be substantially higher or lower than you thought, which could have a huge overall impact on your bottom line.
Fixed spreads and variable spreads both have their advantages and disadvantages. The former allows for more predictable pricing (most of the time) and removes some of the barriers to entry that smaller, individual forex traders often face.
Smaller traders that trade less frequently would benefit more from fixed spreads. Meanwhile, although variable spreads are unpredictable and can eat into your profits, the actual spread prices that you get tend to be cheaper than anything you would find with a fixed spread broker. Therefore, variable spreads are ideal for frequent traders with large amounts of capital to invest.
Find the Right Spreads for You
Different forex brokers offer vastly different spreads and pricing regimes. In order to maximize your chances at profitability, it is essential that you find the broker that offers the best spreads to suit your needs. For this, make sure to consult our expertly-curated, in-depth forex broker reviews to find the right spreads for you.