What is spread?

Forex trading or FX trading is the act of buying and selling currencies at their exchange rates in hopes that the exchange rate will move in the investor’s favor. Traders can buy euros, for example, in exchange for U.S. dollars at the prevailing exchange rate—called the spot rate—and later, sell the euros to unwind the trade. The difference between the buy rate and the sell rate is the trader’s gain or loss on the transaction

Currencies are always quoted in pairs, such as the U.S. dollar vs. the Canadian dollar (USD/CAD)

For example, if it took $1.2500 (Canadian dollars) to buy $1 (U.S. dollar), the expression USD/CAD would equal 1.2500/1 or 1.2500. The USD would be the base currency, and the CAD would be the quote or counter currency. In other words, the rate is expressed in Canadian terms, meaning it costs 1.25 Canadian dollars to buy one U.S. dollar.

In Forex, two types of prices are used to display the price of a currency pair: “Bid Price” and “Ask Price.” The bid price is the price at which you can sell the base currency of the pair. The ask price is the price at which you can buy the base currency of the desired pair. The Forex spread refers to the difference between the bid price and the ask price of a currency pair. In other words, the spread is the cost that an investor must pay to enter a trade.

Forex quotes are always provided with bid and ask prices, similar to what you see in the equity markets.

The bid represents the price at which the forex market maker or broker is willing to buy the base currency (USD, for example) in exchange for the counter currency (CAD). Conversely, the ask price is the price at which the forex broker is willing to sell the base currency in exchange for the counter currency.

The bid-ask spread is the difference between the price a broker buys and sells a currency.2 So, if a customer initiates a sell trade with the broker, the bid price would be quoted. If the customer wants to initiate a buy trade, the ask price would be quoted.

Important Points:

• The spread can vary depending on market conditions, trade volume, and the type of broker.
• Spreads can be either fixed or variable.
• Variable spreads usually widen during volatile market conditions.
• The spread is part of the transaction costs, and traders must account for it in their calculations.
• During certain times (such as economic news releases), spreads may suddenly increase.
• The spread differs for various currency pairs. Major pairs (like EUR/USD or GBP/USD) typically have lower spreads, while less-traded pairs (like exotic pairs) tend to have higher spreads.
• The higher the trade volume, the lower the spread usually is. During peak market hours, such as when European and U.S. trading sessions overlap, spreads generally narrow.
• If you are a short-term investor or a scalper, the spread can significantly impact your strategy, as you depend on small price movements.
• The spread is heavily influenced by market liquidity. In highly liquid markets, such as during peak activity, spreads are generally lower. Conversely, during low liquidity periods, spreads can widen.
• In some markets, such as cryptocurrency markets, spreads can be much larger than in the Forex market. This difference should be considered when choosing a market for trading.
• Different brokers offer different spreads. Some may have lower spreads but include other hidden costs, such as commissions.

How to Calculate Spread

1. Bid Price: The price at which the investor can sell the base currency.
2. Ask Price: The price at which the investor can buy the base currency.
3. Spread: The difference between the Ask and Bid prices.

Formula for Calculating Spread

Spread=Ask Price−Bid Price

Example

Assume:

• Ask Price: 1.1050
• Bid Price: 1.1045

The calculation for spread is:

Spread=1.1050−1.1045=0.0005

 This means the spread is 5 pips.

Trading Strategies and Spread

• Scalping: For scalpers looking for small profits in quick trades, the spread is very important. These traders typically need brokers with lower and faster spreads.
• Day Trading: Day traders should also pay attention to spreads, as they can impact small profits. Choosing a broker with a low spread can be a significant advantage.
• Swing Trading: For long-term traders, the spread may hold less importance since they focus more on overall market trends. However, they should still consider spread costs.

Risk Management

• Spread Analysis: Analyzing spreads before entering a trade can help you better assess risk and profit potential. Considering the spread can help you choose the right time to enter the market.
• Position Size Adjustment: Considering the spread when adjusting position size can prevent unnecessary losses. For example, if the spread is high, it may be wise to reduce your position size.