Forex spread is the difference between the bid and ask prices of two currencies. In Forex trading, spread is a built-in cost that traders pay brokers to facilitate buying and selling transactions.
Spreads in Forex can be fixed or variable. Fixed spreads mean that the bid-ask price gap does not change, while variable spreads mean that the size of the bid-ask price gap may change depending on different factors.
The size of the bid-ask spread is not fixed and can vary. It is influenced by several factors, including market volatility, market liquidity, the time of the day, geopolitical events, and the Forex broker spreads pricing model.
FX spread is calculated in pip (Point in Percentage), corresponding to the smallest price change on a given currency pair. To calculate the Forex spread cost, one must subtract the bid price from the ask price of the currency pair.
What is Spread in Forex?
Spread in Forex is the difference between the buy (bid) price and the sell (ask) price of a currency pair. The spread is charged by a Forex broker as the transaction cost for trading or exchanging currency pairs.
A bid price in Forex spread is the price at which a trader is willing to sell the base currency, while the ask price is the price at which the trader is willing to buy the base currency.
The difference between the bid and ask prices is known as the bid-ask spread. Forex spread is measured in pips, the smallest change unit in a currency exchange rate. One pip is equal to 0.0001 for most Forex currency pairs. For currency pairs involving the Japanese Yen, which are quoted to two decimal places, one pip is equal to 0.01.
Forex brokers gather the price quotations forming the spread from the interbank market, where major financial institutions and liquidity providers engage in large-scale currency trading. Brokers receive bid and ask prices from multiple liquidity providers, and they aggregate these quotes to offer the best prices available to their clients. The spread reflects the broker’s operational costs and profit margin. Aggregated spread is then presented to traders on the broker’s trading platform, ensuring competitive pricing based on real-time market conditions.
Traders consider the FX spread because it affects market conditions and the total transaction costs they incur. Traders adopt different trading strategies and Forex trading patterns depending on how wide or tight the bid-ask spread is.
What is the Importance of Spread in Forex Trading?
Spread is important in Forex trading because it influences trading costs, market liquidity, volatility, and traders’ decision-making, such as the entry and exit points.
A high spread means that traders must pay more to open and close a trade position, making it expensive to enter trade positions frequently. A small spread means traders incur lower costs when executing trades, allowing them to execute trades frequently according to their strategy.
Spreads affect market volatility and liquidity by influencing the number of willing buyers and sellers. Traders prefer highly liquid, low-volatility markets because they offer tight spreads, which make it easier to enter and exit trades at the desired price. Wide spreads usually indicate low liquidity and high market volatility, which causes fewer traders to be willing to pay the high costs of opening trades. Wide spreads, low liquidity, and high volatility form unfavorable market conditions for traders.
The bid-ask spread in Forex trading also directly affects how traders think and make critical trading decisions. For instance, most traders choose the brokers with the tightest spreads and mainly trade the major Forex currency pairs like EUR/USD because they have tighter spreads due to high liquidity.
Scalpers and day traders prefer low-spread currency pairs since the spread cost significantly impacts their strategy’s profitability and should be minimized. Swing traders or position traders suffer less from the impact of a high spread since it has less impact on the profitability of their strategy.
How to Calculate Spreads in Forex Trading?
The four steps for calculating spreads in Forex trading are listed below.
- Obtain the bid and ask prices from the Forex broker: this information is usually displayed on their website and trading platform.
- Subtract the bid price from the ask price: The formula to calculate the spread is Ask price – Bid Price. For instance, if the Bid price of the EUR/USD pair is 1.08575 and the Ask price is 1.08598, the spread is 0.00023 (calculated as 1.08598 minus 1.08575).
- Convert the spread to a percentage: Divide the spread by the ask price and multiply by 100. For example, with a spread of 0.00023 for EUR/USD, the percentage spread is calculated as (0.00023 / 1.08598) x 100 = 0.0211%. Traders use this percentage to compare the spreads of different currency pairs. For many traders, this operation is optional and not necessary.
- Interpret the spread in pips: From the example above, since EUR/USD is a major pair, one pip is worth 0.0001. Therefore, the spread = 0.00023/0.0001 = 2.3 pips. This spread will, however, vary for each trader, depending on the market conditions.
Why do Spreads Vary?
Spreads in Forex vary depending on inherent market volatility, the liquidity of the specific currency pair being traded, the time of day which can influence trading volume and activity, and the type of Forex broker, whether dealing desk or non-dealing desk, each employing different pricing models and execution methods.
Forex brokers widen their spreads during periods of low liquidity or high market volatility to compensate for the increased risk and uncertainty in facilitating trades under such conditions. Forex brokers tighten their spreads during periods of high liquidity or low market volatility as the increased trading activity and stability reduce their risk and allow for more competitive pricing.
Spreads are typically lower for major Forex pairs such as EUR/USD (Euro / US dollar) and USD/JPY (US dollar / Yen) in comparison to minor currency pairs like NZD/JPY (New Zealand Dollar / Yen) and exotic currency pairs like AUD/NOK (Australian Dollar / Norwegian Krone). The major Forex pairs, often denominated in US dollars, benefit from significantly higher trading volumes than minor and exotic pairs. The higher liquidity of major currency pairs enables brokers to match buyers and sellers more quickly and efficiently, allowing for narrower spreads. The lower liquidity of minor and exotic currency pairs necessitates wider spreads, effectively increasing the transaction costs for traders.
Spreads tend to be tighter during peak trading hours in major financial centers such as Tokyo, London, and New York due to increased market participants and resulting liquidity. Brokers widen the spreads during off-peak hours to account for the heightened risk associated with holding positions overnight or during the weekend when there are fewer active participants and lower liquidity.
Spreads vary depending on the type of broker due to differences in their trading models. Dealing-Desk brokers, also known as market makers, set their bid and ask prices and often maintain wider spreads to incorporate their service costs and to ensure profitability from the price differences. Dealing Desk brokers act as counterparties to their clients’ trades, which can lead to potential conflicts of interest but allows them to offer fixed spreads regardless of market conditions. Non-Dealing Desk (NDD) brokers, which include Straight Through Processing (STP) and Electronic Communication Network (ECN) brokers, connect traders directly to the interbank market through liquidity providers. NDD brokers typically offer variable spreads that fluctuate with market conditions, reflecting the supply and demand in the Forex market. NDD brokers earn primarily through commissions on trades or small markups on the spread, providing a more transparent and competitive pricing structure that generally results in narrower spreads during periods of high liquidity.
What are the Types of Spreads in Forex?
The two types of spreads in Forex are listed below.
- Fixed spreads: A fixed spread is a bid-ask spread that remains constant and does not change in response to market conditions. Fixed spreads allow traders to plan their trades and risk management because they know how much they will spend on trade entries and exits. The predictability and stability of fixed spreads make it ideal for novice traders, scalpers, and day traders.
- Variable (or floating) spreads: A variable spread is a bid-ask spread that changes depending on the currency’s supply and demand, liquidity, and market events. Variable spread tightens with high liquidity and widens with low liquidity conditions. The unpredictable nature of variable spread makes it suitable for experienced traders who understand the market conditions and can effectively adjust their trading strategies to accommodate tighter risk management under wide spreads.
How can Spreads Be Effectively Managed in Trading Strategies?
Spreads can be effectively managed in trading strategies by trading only liquid currency pairs, evaluating spread-to-pip potential, trading during active market sessions, and monitoring economic news.
The major Forex pairs are the most liquid currency pairs and typically exhibit the lowest spreads. For example, the average spread for EUR/USD is 1.54 pips, for GBP/USD it is 1.92 pips, for USD/CAD it is 1.91 pips, for USD/JPY it is 1.77 pips, for EUR/JPY it is 2.22 pips, and for EUR/CHF it is 2.52 pips. In contrast, minor and exotic currency pairs generally have higher spreads. For instance, the average spread for NZD/JPY is 3.5 pips, while for exotic pairs like USD/NOK (USD/Norwegian Krone), the average spread is significantly higher at 36.9 pips.
Forex traders evaluate the spread-to-pip potential, the ratio of the average spread of a specific currency pair to the total pip movement of that currency pair over a specific period, such as 12 weeks. Spread-to-pip potential helps traders evaluate the cost-efficiency of trading different currency pairs.
The Spread-to-Pip potential values of the main currency pairs are shown in the table below.
| CURRENCY PAIRS | AVG SPREAD | PIPS 12 WEEKS | SPREAD-TO-PIP POTENTIAL |
| EUR/USD | 1.54 | 58 | 2.66% |
| GBP/USD | 1.92 | 76.57 | 2.51% |
| USD/CAD | 1.91 | 57.92 | 3.30% |
| USD/JPY | 1.77 | 121.89 | 1.45% |
| EUR/JPY | 2.22 | 137.27 | 1.62% |
| EUR/CHF | 2.52 | 54.45 | 4.63% |
EUR/USD and GBP/USD have low spread-to-pip potentials (2.66% and 2.51%, respectively), indicating cost-effective trading due to high liquidity and lower transaction costs. Conversely, EUR/CHF, with a higher spread-to-pip potential of 4.63%, signifies higher relative costs. With spread-to-pip potential, traders can focus on currency pairs that best balance transaction costs and potential returns. Pairs with lower ratios, such as USD/JPY (1.45%) and EUR/JPY (1.62%), are generally more attractive for trading. This approach helps optimize trading strategies, particularly for frequent trading where minimizing transaction costs is crucial.
Traders may prefer to trade during active market sessions (e.g., Tokyo-London and London-New York overlap) when spreads are generally lower. The larger number of participants during these market sessions increases the possibility for brokers to match buyers and sellers more efficiently, resulting in tighter spreads.
Traders can avoid trading during economic news releases to mitigate the heightened risk of market volatility and unpredictable price movements. During economic news releases, the influx of new information can lead to rapid and substantial shifts in market sentiment, resulting in wider spreads and increased slippage. These conditions can adversely affect trade execution and significantly impact trading outcomes.
What are the Implications of Spreads?
The implications of spread in the market are listed below.
- Cost of trading: Wider Forex spreads increase traders’ trading costs, reducing their potential profits. Tight spreads lead to low transaction costs, enhancing profitability.
- Trade execution: Wide spreads increase slippage, forcing traders to open trades at unfavorable positions. Wider spreads lead to reduced profits and potential extra losses.
- Trading strategy: Wide spreads are less impactful for long-term swing trading strategies with large profit goals because the cost of the spread becomes less significant relative to the potential profit over time. In contrast, tight spreads are ideal for short-term scalping strategies with small profit targets, as lower transaction costs are crucial for profitability when aiming for small, frequent gains.
- Risk management: Wide spreads require traders to set wider stop-loss positions to maintain the desired risk-reward ratios, increasing risk exposure.
- Market liquidity and volatility: Tight spreads typically signify a market characterized by high liquidity and low volatility, whereas wide spreads generally indicate a market with low liquidity and high volatility. Understanding market conditions regarding liquidity and volatility gives traders insight into the current market environment and informs their trading strategies accordingly.
- Broker selection: Traders prefer brokers that offer the tightest spreads, fast execution speeds, and robust regulatory oversight. Traders seeking predictability may opt for brokers providing fixed spreads, while those prioritizing tighter spreads might choose brokers offering variable spreads.
How Does Spread Influence the Effectiveness of a Chart Pattern in Trading?
Spread influences the effectiveness of chart patterns in trading by affecting the entry and exit positions, stop loss and take profit levels placement, pattern confirmation, and the overall risk-reward ratio.
Wide spreads prevent traders from executing trades at precise entry or exit points, as indicated by different types of chart patterns. For example, traders using continuation patterns like the ascending or descending triangles might look to enter trades at the breakout zones above or below the pattern lines. However, due to a wide spread, their position is executed within the pattern boundary, effectively anticipating the pattern’s confirmation and thus potentially undermining the overall profitability of the trade.
Wide spreads force traders to place stop-loss and take-profit levels at less favorable levels to avoid premature stop-outs or missed profit targets. Sudden spikes in spreads invalidate chart patterns or lead to many false breakouts, which make it harder to confirm patterns.
Spread variation compromises the reliability of a backtesting-based chart pattern strategy if the backtesting is conducted using a fixed spread. Failure to consider the wider spread variations could result in higher losses, even with confirmation of chart pattern trades.
What is a Good Spread in Forex?
A good spread in Forex trading ranges from 0 to 2 pips for major Forex pairs, 2 to 5 pips for minor pairs, and around 5 to 20 pips for exotic pairs. Major pairs such as EUR/USD, GBP/USD, and USD/JPY benefit from high liquidity, allowing brokers to offer spreads as low as zero pips. Brokers offering zero spreads generate income by charging commissions based on trade volume or lot size.
Minor currency pairs, like GBP/CAD or EUR/AUD, exhibit higher liquidity than exotic pairs but are generally more volatile. Spreads for minor currencies can reach up to 7 pips, depending on market liquidity.
Exotic currency pairs, such as EUR/ZAR or USD/TRY, have the lowest liquidity in the market, leading to extreme volatility and increased trading risk. Brokers charge higher spreads on exotic currency pairs, which can be as high as 100 pips, to compensate for the high risk.
What Factors Influence the Size and Variation of Spreads in Forex?
The factors that influence the size and variation of spreads in Forex are listed below.
- Liquidity providers: The number and quality of liquidity providers a broker can access can significantly impact spread size. More liquidity providers generally mean better prices and tighter spreads, as competition among providers ensures favorable trading conditions.
- Market volatility: Brokers tend to widen spreads during periods of high volatility, such as major economic news releases like CPI, interest rates, and employment data (NFP).
- Market liquidity: Major currency pairs like EUR/USD offer tighter spreads because they are more liquid than less liquid minor and exotic Forex pairs.
- Time of day: The Tokyo-London and London-New York overlap sessions are the most liquid times on the market, meaning traders experience narrower spreads during these periods compared to other off-peak hours.
- Geopolitical events: political tensions and instability in countries, as well as natural disasters like earthquakes and hurricanes, create uncertainty in the markets, which leads to increased volatility risks. Brokers widen their spreads during such periods to cover the risks.
- Broker pricing model: Dealing brokers often set wider fixed spreads compared to the variable spreads from non-dealing brokers. Brokers not charging a commission also offer wider spreads to cover their operation costs and profit margins.
What does 0.3 Spread Mean?
A 0.3 spread in Forex means that the difference between a currency pair’s bid price and ask price, measured in pips, is 0.3. This is the cost that a trader pays the broker to execute a trade. For example, if the bid price for EUR/USD is 1.0800 and the ask price is 1.08003, then the spread is 0.3 pips.
A 0.3 pip spread, in actual trading costs, on a standard lot (100,000 units) would translate to a transaction cost of $3 (0.0003 x 100,000).
Is a Higher Spread Better?
No, a higher spread is not better in Forex trading. A high spread means that traders pay their FX brokers a higher transaction cost for each trade, leading to lower profitability. A low spread is better because it leads to lower transaction costs and potentially higher profitability.