In the earlier days, foreign exchange was only relevant for businesses and economies that carry out transactions on a global level. Conversion of one currency into another was essential for various economic activities that involved parties using different currencies as a medium of exchange. But these days, the popularity of the forex market is attributed to high-volume currency trading that happens on a daily basis. The sole intention of forex trading is to make profits from exchange rate changes, and forex currency pairs have become the most traded asset class due to the high liquidity and volatility, which creates a lot of good trading opportunities.
However, a trader needs to know about the various costs involved in trading before entering the forex market. This article will also be talking about one key component of forex trading cost, which is the spread charges.
What is the Spread in Forex?
To know the basics of forex spreads, you need to understand the purpose behind spreads. An average trader cannot access the forex market on their own as they have to sign up for a trading account with a forex broker of their choice. This broker will be in charge of providing all trade-related services, ranging from offering a trading platform to providing enough liquidity and making the trading instruments available for trading at the best prices. But the broker also needs to make profits, and for this, they adjust the prices.
This adjustment in the prices of currency pairs is what we see in the form of spreads in trading. The price at which the trader buys a currency pair is said to be the bid price, and the price at which they sell it is referred to as the ask price. The difference between the bid price and ask price is stated as spreads, which become a part of your trading cost. A currency pair with higher trade volume will have lower spreads as the broker earns enough from the numerous traders buying and selling the pair.
Similarly, when you decide to trade a currency pair with low trade volume, you will have to pay higher spreads as only a few buyers and sellers would be there for the pair. So, we can say that the demand and supply of various currencies highly influence the spreads. Now, brokers who don’t charge any commission for trades will add that to the spreads, while brokers providing narrow spreads will charge a reasonable commission for the trades that get executed. Profits are calculated after including the spreads, so if you find a difference in the profits you’ve actually earned and the profits you received, then that is because of the spreads. To accurately calculate your profits in your base currency, you can use a profit calculator, and you’ll get to know how much you have made from your trades.
How Do Forex Spreads Work?
The working of forex spreads depends on the forex broker you are dealing with, as different brokers use different methods for charging spreads. Some brokers charge fixed spreads on currency pairs, which means the spreads remain unchanged irrespective of the market situation and other external factors. This means you will be paying the very same pre-agreed spread in all trading scenarios.
However, most brokers providing solid trading conditions will offer floating spreads instead of fixed spreads. Here, the spreads will change based on the real-time market conditions and other factors that influence the spreads. However, the trading cost is minimal when you choose a broker offering floating spreads and low commission.
The fixed spreads are beneficial in some cases due to the assurance that comes with it, but they are always higher than variable spreads, which makes many traders go for floating spreads. Floating spreads allow them to make the most out of a favourable market situation as the spreads will drop to the lowest level in an ideal scenario, which never happens in the case of fixed spreads, as they remain unchanged until there is a periodic revision.
Most brokers display their real-time spreads on their website, and you can check the same for further clarification. We can make the working of spreads clearer with a practical example. Suppose you decide to trade with the USD/JPY pair, and you check the spread information provided by your broker. You see, the bid price is 144.557, and the ask price is 144.561, by which the difference in prices is 0.004, which is the spread charged by your broker.
Some brokers offer different types of accounts with different trading conditions. Some brokers provide a zero-spread account where you will pay a higher commission to compensate for the spread loss. Choosing a raw spread trading account would be the best course of action for traders who want to trade with ultra-low spreads.
The mode of execution offered by the broker will also impact the spreads. For instance, brokers providing ECN execution tend to charge lower spreads than STP brokers. The working and determination of forex spreads is actually a complex process that is often tough to comprehend for an average trader. However, choosing a broker offering tight spreads is essential for minimising the trading cost.
What Affects the Spread in Forex Trading?
As we mentioned earlier, the forex spreads are influenced by many internal and external factors. However, the primary determinants of market spread are liquidity and volatility. Liquidity is directly related to the volume of trade a currency pair has at the moment, and volatility is a measurement of the price fluctuations that take place during a specific time frame. The spreads tend to be lower during the peak hours with the highest trading volume, which happens during the major trading sessions and session overlaps in the forex market.
Speaking about the effect of market volatility on spreads, you will see that the spreads are always higher during volatile market hours. You can also see the same effect while trading with different types of currency pairs in the forex market. Major pairs have the lowest spreads due to high liquidity, and minor pairs will have slightly higher spreads due to increased volatility.
However, exotic currency pairs, which have low liquidity and high volatility, are the most expensive when it comes to spread charges. Since the number of buyers and sellers is lowest for exotic pairs, brokers will charge higher spreads on these. So, for traders who want to minimise spreads, trading with major pairs during a major trading session and staying out of the market during volatile hours would be ideal.
How to Calculate the Spreads While Trading?
The spreads in forex become a part of the price at which you buy or sell the currency pair. Since pips are used as a standard unit of measurement to state the currency price fluctuations, the same is used for stating and calculating the spreads as well. In the above-mentioned example, we saw that the spread for USD/JPY is 0.004, calculated in pips. Basically, you determine or calculate spreads by deducting the bid price from the ask price of the currency pair. Manually calculating spreads or pip movement can be tiring; therefore, you must use trading tools to calculate such values accurately. Your trading experience will improve significantly once you start using trading tools.
Reason for Changes in Spreads
There can be many reasons for changes in spread, but the most common situation is a major economic event or news release leading to higher volatility and thereby resulting in higher spreads. The higher spreads are normal when the market has been hit by impactful news, and because of this, many traders try to avoid trading during a news release as the chances of being caught up in sudden volatility are higher. If the high volatility continues without enough liquidity, you may also encounter slippage, price re-quotes, and higher spreads.
Finally, traders need to remember that spreads are unavoidable in forex trading, but you can always look for ways to minimise the trading cost. Choosing a low-spread broker, trading major currency pairs, only trading during major sessions and staying out of the market during volatile hours are some ways to save yourself from paying higher spreads. But you also need to consider the commission and swap rates charged by your broker, as they also become a part of your trading cost in the forex market.