What is a Spread in Forex Trading?

Trading in the forex market means exchanging one currency for another at a fixed exchange rate. As a result, currency prices are quoted in terms of their value in another currency. The spread refers to the difference in the price at which a forex broker sells a currency and the price at which the broker purchases the currency.

A currency pair consists of 2 prices the bid price and the ask price. In contrast to the ask price, which you would pay to buy the base currency, the bid price is the price at which you may sell the base currency. In forex terms, the spread is the difference between the bid price and the ask price of a currency pair. The currency pair’s base currency appears on the left, while the quote currency is shown on the right.

The quotation for the currency pair shows how much of the second currency is required to purchase a single unit of the first currency. The real market price will always lie somewhere between the stated cost of buying and the quoted sell price, with the difference being the listed buy price.

The foreign currency market includes numerous participants, including forex brokers, individual investors, investment firms, financial institutions, and governments, with a daily trading volume of $7.5 trillion. This high trading activity has an impact on currency demand, exchange prices and the forex spread.

How forex spread works

The majority of currency pairs in the world of forex are traded without any commission charged. The spread, on the other hand, is the cost of trading. In other words, it is a cost that all transactions must pay. Forex brokerages will add a spread to the cost of placing a transaction instead of a commission, which explains why the ask price is greater than the bid price.

The spread size is affected by a variety of factors including the currency pair you chose to trade as well as how volatile it is, the amount of money you placed, and the broker that you are using. The EUR/USD, GBP/USD, USD/JPY and USD/CHF are some of the most popular major currency pairs.

Investors should keep an eye on brokers’ spreads since each trade must cover or profit sufficiently to pay the spread and any other related fees. In addition, each broker can increase their spread, which enhances their profit per trade. When the bid-ask spread is bigger, a trader will pay more when buying but get less when selling. In other words, each forex broker may charge a slightly different spread, increasing the cost of currency transactions.

How to quote spreads

The U.S. dollar and the Canadian dollar are two examples frequently quoted in pairs (USD/CAD). USD is the base currency and CAD is the counter currency, often known as the quote currency.

For instance, the currency pair USD/CAD would be equal to 1.2500/1 or 1.2500, if it cost $1.2500 (Canadian dollars) to buy $1 (U.S. dollars). The base currency would be the USD, and the quote or counter currency would be the CAD. In other words, because the conversion rate is given in Canadian dollars, one US dollar is equivalent to 1.25 C$.

However, certain currencies are quoted in terms of the US dollar, making the USD the quoted currency. For instance, the quoted price for the British pound at the 1.28 US dollar conversion rate would be $1.2800 (US dollars). The base currency is the pound, and its exchange rate is expressed as GBP/USD.

Depending on the currency involved, spreads might be tighter or wider. Usually, the gap between the two prices is 1-5 pips. However, depending on market conditions, the spread might fluctuate and change at any time.

Factors affecting the spread in Forex

Aside from the broker, additional factors could increase or reduce a forex spread.

Time the trade was placed

The time of day, when a trade is placed, is significant. Trading in Europe for example, begins in the early hours of the morning for US traders, while in Asia it opens late at night for US and European investors. If a euro transaction is entered during the Asian trading session, the currency spread will most likely be significantly wider than a trade entered during the European session.

Put simply, there won’t be many traders trading that currency if it’s not the typical trading session, which results in a lack of liquidity. An illiquid market means that there aren’t many market participants which makes buying and selling of the currency harder. Forex brokers, therefore, raise their spreads to reflect the possibility of a loss if they are unable to exit their position.

Market events & volatility

Political and economic events can also widen FX spreads. For instance, if the U.S. unemployment rate came in much higher than anticipated, the dollar would most certainly weaken or lose value in comparison to the majority of currencies. When such events occur, the currency market may move quickly and become highly turbulent.

Due to the tremendous volatility of currency values during market events, forex spreads can become quite large. A forex broker may find it difficult to determine the true exchange rate during times of event-driven volatility, which forces them to charge a bigger spread to reflect the increased risk of losing money.

Pip spread in forex trading

The last decimal point on the price quotation (equivalent to 0.0001) and the smallest unit of movement in the currency pair price, are called pips which are used to calculate the spread. With the exception of the Japanese yen, where the pip is the second decimal point (0.01), the majority of currency pairs have this characteristic.

Wider spreads indicate higher price differences between the two prices, which typically translates to limited liquidity and high volatility. On the other side, a smaller spread denotes good liquidity and minimal volatility. Trading a currency pair with a tighter spread will consequently result in a lower spread cost.

The spread while trading forex can be either constant or variable. Since the spread for forex pairs is unpredictable, it fluctuates along with changes in the currency pair’s bid and ask prices.

Disclaimer:

This information is not considered investment advice or an investment recommendation, but instead a marketing communication. IronFX is not responsible for any data or information provided by third parties referenced or hyperlinked, in this communication.