The spread is a major concept in forex trading and it is basically the transaction cost for a trade. The trading fee that a trader pays affects the total cost of trading, that’s why it should be a key consideration when choosing a reliable Forex broker.
What is the Spread?
It is defined as the difference between the bid and ask price of a currency pair. That is usually measured in pips, the smallest unit of price movement. The larger the gap, the higher the spread. It can be very small in a high liquidity market, but when the market is less liquid, spreads will be wider.
The bid price is the price that the trader is willing to pay for the traded asset. The ask price is the price that the trader is willing to receive from selling the traded asset.
When trading currencies, a quote for a EUR/USD currency pair can be displayed as $1.1524/27. The first figure represents the bid price of $1.1524, while the second figure represents the ask price of $1.1527, and the difference between the two is the spread worth of 3 pips.
In forex trading, currencies are traded in pairs, as currencies are defined as base currency and secondary quote currency. A currency pair measures the value of one currency against another.
A base currency is the first currency in a currency pair. Also known as the transaction currency. The quote currency is the currency being used to pay for the transaction, and it is also known as the counter currency, or secondary currency. Read more about Quote Currency and Base Currency.
How to Calculate Spread in Forex Trading
It is typically calculated by subtracting the bid price from the ask price within the price quote. It is measured in pips, the last decimal point on the price quotation of a currency pair. In the Japanese yen pairs, it is the second decimal point.
For example, if the bid price for the currency pair GBP/USD is 1.2540 and the ask price is 1.2545, to calculate the spread just subtract the bid price (1.2540) from the ask price (1.2545) that equals to 0.0005.
The higher the difference between ask and bid prices, the wider the spread is. This usually reflects low liquidity and trading volumes, and often high volatility. While low spreads reflect high liquidity and low volatility. Major currency pairs are usually traded with tight spreads due to high trading volume and liquidity levels.
Spreads can be influenced by many factors that include market volatility, the traded instrument and liquidity.
Different Types of Spreads
There are two main types of spreads in the forex market; fixed and variable.
Fixed: it is the simplest form, which is novice-friendly. The fixed type guarantees that the difference between Ask and Bid prices remains the same even with changing prices. Nevertheless, it is very helpful for accurate trading cost planning, better risk management and protects the trader from higher trading costs. This type generally suits scalpers and other short-term traders.
Variable: also referred to as floating, they are variable fees depending on the instrument traded, broker, and market conditions. The difference between the buy and sell price of a particular currency pair may fluctuate in a range. It changes as the bid and ask prices of a currency pair change. The variable fees tend to be lower than fixed ones in a high liquidity market. However, traders may get exposed to wide spreads during high volatility or low liquidity periods. This type works better for long-term traders as they have the luxury of less restricted timing for opening their positions.
Spread Vs. Commission Explained
The spread is defined as the cost that applies to forex trades. While the spread refers to the trading cost, the commission is known as the compensation for trading intermediaries in non-spot forex, it is less popular in the retail Forex industry. Zero-spread and ECN accounts usually have some sort of commission, which is based on trade volume. This type is preferred by traders who prefer to trade news and low liquidity markets.
By paying commissions, which are usually high, traders avoid abnormal wide spreads, requotes, and slippage. Most forex currency pairs are traded without commission. But brokers will apply spreads that will be affected by the currency pair traded, volatility level and the lot size of the trade. The entire amount is paid upfront, compared to the commission that is charged on entry and exit levels.
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