Many people who get into forex trading think that the most important part is predicting the market’s direction. Though that is a crucial part, experienced traders understand that forex trading also consists of costs that have to be kept to a minimum in order to acquire as much profit as possible. One of the most important costs is the spread. Spread can be defined as the difference between the bid and ask price of a currency pair. This difference is a crucial part of every trade.
Mastering the concept of spread is crucial whether you are a beginner trader or an experienced one. It can affect both short-term and long-term strategies since even small spreads can add up to significant costs when a trader opens and closes multiple positions in a day. Spread can also determine entry and exit points for swing or position traders. Overall, understanding spread is important for all types of traders. In this article, we will go over what spread is in forex trading, how it works, and how it can be managed effectively.
What is Spread in Forex?
A spread in forex trading is the difference between the highest price a buyer is willing to pay (the bid price) and the lowest price a seller is willing to accept (the ask price) for a currency pair. Spreads are usually measured in pips, which are the smallest unit of price movement. An example of spread in forex is this case: If the bid price of the EUR/USD currency pair is 1.1000 and the ask price is 1.1005, then the spread (the difference) is 5 pips.
In its essence, a spread is what a trader pays to enter a position. In other words, there is an automatic cost inherent in every trade that starts each trade at a slight disadvantage, but when the price moves far enough in favor of the trader far enough, it effectively covers the spread. Studies also exist of macroeconomic factors affecting spreads.
Spreads are used by brokers to earn revenue, especially in commission-free trading models. A small or tight spread means a lower cost of trading. Because of this, understanding spreads and trying to manage them as tightly as possible is an important part of forex trading and a principle of professional trading.
How Does Spread Affect Profit in Forex?
Spread directly affects the profitability of every trade since the position is opened. This means that as as a trader enters a position, the trade shows a small loss equivalent to the amount of the spread.
The wider the spread, the more it can affect high-frequency trading strategies. For example, if the average target profit is 7 pips per trade and the spread is 4 pips, the trader is essentially cutting their own profits. When it comes to long-term trades, the pips might not make a significant difference, though they still influence the final profit.
What Is Tight Spread in Forex?
A tight spread refers to a small difference between the bid and ask price of a currency pair. The benefit of a tight spread is that it reduces the cost of entering and exiting a trade. Traders can usually find tight spreads when it comes to major currency pairs such as EUR/USD, USD/JPY, and GBP/USD, especially during high volatility moments in the market. This is because major currency pairs have high trading volumes and low volatility when compared to exotic currency pairs. To access tight spreads, traders are better off looking for brokers that aggregate prices from multiple liquidity providers and offer different trading account types.
Types of Spread in Forex
Not all spreads are the same. There are different types of spreads in forex, in addition to the fact that different brokers offer different spread models. Even in the same broker, spread models may depend on market conditions, liquidity, the currency pair being traded, and more.
Three main spread types are fixed, variable, and floating, choosing between them depends on one’s trading style in addition to risk tolerance.
1- Fixed Spreads
A fixed spread does not change based on market volatility. Using a fixed spread means that the trader doesn’t need to worry about market volatility changing the spread since the difference between the bid and ask prices stays the same. These types of spreads are often preferred by traders who want constant and consistent trading costs, no matter market conditions. Fixed spreads are usually offered by dealing desk brokers.
2- Variable Spreads
As the name suggests, variable spreads fluctuate based on market conditions. On one hand, when there are periods of high liquidity and low volatility, for example, the spreads are narrower. On the other hand, when there is market volatility, such as when there’s a news release or an unexpected event, these spreads widen. Variable spreads are usually offered by non-dealing desk brokers.
3- Floating Spreads
Floating spreads also fluctuate like variable spreads. The difference is that they are specifically designed to change in real time based on market conditions. Floating spreads are used by brokers who aggregate prices from various liquidity providers. The benefit of floating spreads is that traders can sometimes profit from their tight spreads during stable markets.
Spread vs Commission – Which is Better?
Forex brokers either charge a commission or a spread or both. When a broker uses a spread-only model, it also includes its fees into the difference between the bid and ask price resulting in wider spreads. When a broker uses a commission-based model, spreads are usually tighter, but there are fixed fees (commission) that are charged per trade volume.
In the case of scalpers and day traders, tighter spreads are more beneficial, in general, since they are more cost-effective. So it’s better for them to use commission-based models. However, commission-based models can be more frustrating for beginners seeking simplicity when starting from square one.
Traders who hold positions for longer periods can find that spread-only accounts might be more beneficial to them. They can avoid the complexity of tracking commissions while also benefiting from competitive pricing when it comes to major currency pairs.
What Causes High Spread in Forex?
High spreads are caused by a number of factors. For example, in times of economic uncertainty and market volatility, the bid and ask prices start to diverge, leading to increasing spreads. In other words, it is a reflection of the uncertainty of liquidity providers in that period.
Liquidity itself determines spread size. When it comes to low-liquidity markets or off-peak trading hours, for example, the liquidity of markets starts to shrink and spreads start to widen. Examples can be seen in exotic currency pairs where trading volume is low.
How to Avoid Spread in Forex
Though there aren’t any ways to get rid of spreads forever, traders who want to maximize profits can find ways to minimize the impact of spreads. The most straightforward method is to simply trade during peak market hours, which means liquidity is at its highest, resulting in tight spreads. For many major currency pairs, the overlap of London and New York trading sessions, for example, is considered the time to trade with tight spreads because they are market peak hours. That being said, it is best for traders who are starting out to start with the best markets to trade for beginners, which might not necessarily be the markets with the tightest spreads.
Using other traders’ strategies, or social trading, can also be effective in bypassing wider spreads. Forex brokers that offer ECN or STP accounts often use floating spreads which allows for extremely tight spreads during stable markets, so choosing thse types of brokers can be another method for traders.
Trading at the time of major new releases can lead to volatile conditions. During these times spreads start to widen, which makes trading effectively more difficult. Also, using limit orders, which define your desired entry price, can help bypass wide spreads when the markets are moving fast.
Adhering to anti-margin call strategies and hedging in negative margins can help maintain liquidity for the trader if the cost of a spread combined with the market moving against the trader might result in a margin call.
Conclusion: Mastering Spreads for Smarter Forex Trading
Understand the concept of spread in forex is essential for all traders, whether they are beginners or experienced. This is because spreads are considered primary trading costs that all traders have to find a way to deal with. Traders have to be weary of allowing spreads to affect profitability significantly. All these major reasons as to why articles such as these, explaining how spreads work are important for traders to read and share.
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