How is spread calculated in forex trading?

The forex exchange market is arguably one of the most popular financial markets in the world. It’s where currency pairs are traders by individual traders, investors, banks and other institutions. One of the most essential components of trading forex is the concept of spread. That’s what we’ll be discussing in this article.    

Let’s begin by defining what spread is

The spread in forex is the difference between the buy (ask) and sell (bid) price of a currency pair. The bid price is ultimately the highest price that a trader is prepared to pay for a currency pair. In contrast, the ask price is the lowest price at which a seller is willing to sell the currency pair. The spread is how a broker who charges no commission typically makes their money.

How are currencies quoted?

To properly understand the concept of spreads, one must know how currencies are quoted.

• Currencies are always quoted in pairs.
• The first currency listed is known as the base currency whereas the second currency is called the quote currency.
• For e.g., the British pound versus the United States dollar (GBP/USD): the base currency is the GBP and the USD is the quote currency.

Forex is usually traded in a specific number of lots. There are 4 most popular lot sizes are standard (100k units of currency), mini (10k units of currency), micro (1k units of currency), and nano (100 units of currency). Forex trading orders are placed on a trading platform in sizes quoted in lots. 

What types of spreads are there?

There are two types of spreads that traders typically use, fixed and variable. A fixed spread is the difference between the bid and ask price that remains constant, despite market conditions. Fixed spreads are popular because they offer a measure of predictability and transparency in terms of cost.

However, this is not to say they aren’t impacted by market fluctuations and may widen when volatility arises. In contrast, variable spreads are those that change as a result of market conditions. Consequently, they may narrow when the market is quiet but widen during times of higher volatility. 

How forex spread is measured

The spread in forex trading is measured in pips. This stands for percentage in point or price interest point. A pip is described as the smallest price change increment of a currency pair. The majority of currency pairs are priced out to four decimal points. The 4^th decimal place is a single pip. In other words, a single unit move of $0.0001 = one pip. Notably, the only currency exempt from this rule is the Japanese Yen pairs that are quoted with 2 decimal places and not 4.

How pips (spread) are calculated

The value of a pip is typically determined by the specific currency pair. In the case of EUR/USD (where the USD is the quote currency), the pip is usually fixed at 0.0001. For example, if 10,000 euros are purchased against the dollar at 1.0501 and sold at 1.0511, the profit is 10 dollars or 10 pips. However, when the USD is the base currency, for e.g., USD/AUD, the exchange rate impacts the pip value. In other words, the value of a single pip could be several dollars. What does this mean though? Well, the 0.0001 is essentially divided by the USD/AUD exchange rate, let’s say 1.5500, and then multiplied by a standard lot size of 100,000. The pip value is thus $6.45. In this scenario, if 100,000 USD was purchased against AUD at 1.5500 and sold at 1.5501, the profit equals to $6.45 or 1 pip.

Why understanding spreads is important

Forex spreads impact a trader’s potential profits or losses. For this reason, it’s vital that a forex trader has a proper grasp on the factors that impact spreads which typically include:

1. Market volatility (usually, the higher the volatility the wider the spreads)
2. The currency pair (major vs exotic pairs)
3. Liquidity of currency pairs (more liquidity usually = tighter spreads)
4. Trading sessions (spreads can vary depending on the time of day)
5. Economic news and global events (sometimes leading to wider spreads) 

There are many ways to manage the impact that these factors have on spreads. A strategic risk management plan is incredibly useful to mitigate unanticipated capital losses. Using an economic calendar to monitor news, announcements, and events worldwide is useful to stay informed. Choosing a forex broker that best aligns with your trading needs is another way to reduce risk. Using a demo trading account to learn more about trading and managing spreads is also very useful.

Sign up for a demo trading account with IronFX

As with most things in life, practice makes (near) perfect. Forex trading is no exception. To become a more skilled trader and know how to maximise profit through spread, practice is critical. One of the most optimal ways to gain this experience is through a demo trading account through IronFX, an award-winning global broker.

A demo trading account offers a trader a simulated trading environment that mimics real-life trading. Using virtual money, a trader is able to execute trades and assess outcomes without putting their own funds at risk. A demo account is a great learning resource. With it, a trader can learn more about analysis, technical indicators and charting to make well-informed trading decisions. The demo trading account is also a wonderful way for a forex trader to discover more about the power of the MetaTrader 4 (MT4) trading platform, arguably one of the most popular platforms in the world.

Over time and with enough practice, you will have acquired a robust understanding of what forex trading entails. You will have learned more and understood the concept of spreads and know how to implement various trading strategies. Once you’ve built up enough confidence, you can then move onto a regular trading account to begin live trading.

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IronFX strives to offer its global traders a top-tier trading experience. It provides access to 500+ tradable instruments across 6 asset classes, like shares, indices, forex, futures, metals and commodities. Traders can choose from multiple trading accounts, all of which cater to the different needs of individual traders. IronFX also offers fantastic trading opportunities through flexible leverage, competitive spreads, mobile trading, fast executions, quick and easy deposits and withdrawals, etc. IronFX also provides a multitude of exceptional educational resources to widen a trader’s scope of knowledge and boost their skills. A multilingual client support team is also available to provide assistance and answer your most pressing questions.

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.