What is Spread?
There are more than enough analytical articles about Forex online but they often use specialized terms that only experienced traders can understand. In order to learn how to make a profit on the foreign exchange market, every beginner needs to be familiar with the glossary of terms and expressions used in Forex trading. In this article, we will look at the concept of spread, learn the difference between floating and fixed spread and analyze the main factors affecting the size of the spread.
What is Spread?
Spread is the gap between the buy and sell prices of an asset. In the chart, the buy price is signified by the "Bid" line, and the sell price – by the "Ask" line.
Buy positions are opened at the ask price and closed at the bid price. And vice versa, sell positions are opened at the bid price and closed at the ask price. The spread between the buy and sell prices shows the cost of opening a trade. This means the trader always opens a position with an initial loos equal to the size of the spread. So the higher the spread of a trading instrument, the greater the initial loss.
In the example below, the current bid and ask prices of the USD/CAD currency pair are 1.26315 and 1.26319 Canadian dollars, respectively. In this case, a Buy trade will be opened at the Ask price 1.26319, and a Sell trade – at the Bid price 1.26315.
The size of the spread can vary significantly for different assets due to supply and demand. For example, the spread for a currency pair with the dollar as the base currency will be smaller, since there is no deficit in the number of buy/sell trades opened for this currency pair. The more trades are opened for a particular asset, the higher its liquidity. The spread for these trades will almost always be less than the spread for a less popular currency. Another example is the Norwegian krone, which is a less popular currency to trade. So due to low liquidity, the size of the spread between the buy and sell prices will be higher.
How to find the size of the spread?
As an example, let's say we have a bid price for the EUR/GBP pair at 1.32718. This is the maximum price at which other traders are willing to buy euros. We also have a bid price of 1.32729 at which traders are willing to sell euros. In this case, the spread is 11 points.
For some types of accounts, Forex brokers also add a fee to the spread that’s specific for each trading instrument - markup. It constitutes the profit of the Forex broker and is indicated in points.
How to calculate the cost of the spread?
Spread fluctuation is calculated in points. A point is the fifth digit after the decimal point in the quote. In order to understand how much a trader pays in spread, we need to find out the cost of one point. To do this, use the following formula:
(Trade currency in USD) x (trade volume in lots) x contract size x (point) / (current rate)
If we have opened a buy position in the EUR/GBP in the amount of 1 lot at a price of 1.32718, then the calculation formula will be:
(Trade currency in USD) is the EUR/USD rate - 0.90544
Trade volume - 1 lot
Standard contract size - 100,000
Point - 0.00001
Current EUR/GBP bid price - 1.32718
Total: 0.90544 x 1 x 100,000 x 0.00001 / 1.32718 = 0.68 USD
If you want to calculate the cost of the spread for open trades, the formula is as follows: cost of 1 point x spread (in points)
0.68 x 11 = 7.48 USD
It is important to know that when opening a sell trade “Trade currency to USD” and “Current rate” are calculated at the Ask price.
Why does the spread change?
Spread can change multiple times during a trading session. The spread changes or “floats” because sellers place orders with different prices. For example, some traders want to sell an asset. They offer different prices and the lowest price is $100. At the same time, the opposite group of traders want to buy the asset, and $90 is the highest of the offered prices. In this case, the spread between the highest buy price and the lowest sell price is $10.
When a buyer appears who is willing to buy an asset at $100, the lowest sell order will be closed. Therefore, the next order, for example, with a sell price of $120, will become the lowest price offer. In this case, the spread will widen and become $30. When another buyer places a buy order at $115, the spread narrows to $5.
What affects spread on Forex?
Several factors affect the spread.
Time of the trading session. The time of day affects the size of the spread. Depending on the trading instrument, spread will be lower during the open time of the main markets.
Volatility level of the asset. Volatility is the range of changes in the price of an asset over a certain period of time. The more active buyers and sellers there are in the market, the smaller the spreads will be. In moments of uncertainty, such as the release of important economic news, participants leave the market, which leads to a drop in liquidity and a sharp widening of the spread.
Liquidity of the asset. The higher the supply and demand for a trading instrument, the lower the spread for this instrument.
Spread types (Fixed spread vs Floating spread)
Fixed spread is a type of spread that remains the same regardless of the market situation. Usually, the fixed spread is larger than the floating spread. Another advantage of the fixed spread is that the trader can calculate the cost of opening a position in advance.
Brokers which work are based on the DD system often use fixed spread because they control the market and are counterparties to their traders' transactions.
Floating spread is a type of spread that changes following market dynamics. Usually the floating spread is smaller than the fixed spread. However, in times of high market volatility, for example, during releases of economic news, spread can widen significantly. Therefore, floating spreads can lead to higher execution costs for traders as compared to fixed spreads.
Floating spreads are used by brokers working on the NDD system. They cannot use a fixed spread, as they are only intermediaries between traders and liquidity providers and cannot interfere with trading. The current spread is determined by the economic situation on the interbank market.
Every trader has to pay the spread amount during the active trading, as this is one of the main methods for brokers to receive income. To know how to reduce your expenses, it is important for every trader to carefully study the definition of a Forex spread and to understand how much and why traders pay it.
Article last updated: 2022-10-28