What is spread in Forex trading?

In Forex trading, the spread is the difference between the bid price (what buyers are willing to pay) and the ask price (what sellers are asking for).

This spread represents the broker’s fee for executing the trade. Traders must overcome the spread to make a profit, meaning the asset needs to move in their favor by at least the spread amount to break even.

It can be broadly classified into two types: fixed spread and variable spread. Fixed spreads remain constant regardless of market conditions, offering predictability. In contrast, variable spreads fluctuate based on market liquidity and volatility.

The variation in spreads is heavily influenced by factors such as market volatility and liquidity. During times of high volatility, spreads often widen as the risk for the broker increases. Similarly, in highly liquid markets, spreads tend to narrow, reflecting lower risk and cost for the broker. This liquidity typically correlates with the popularity and stability of a currency pair; major pairs like EUR/USD often have tighter spreads compared to exotic pairs.

Wider spreads usually indicate higher trading costs and can be more challenging to overcome, especially in short-term trades. Conversely, narrow spreads signify lower costs, making it easier to profit from small price movements.

How does spread work in Forex trading?

Forex spread represents the broker’s fee for executing a trade and varies based on factors like liquidity of the currency pair, market volatility, broker’s business model, cost and risks and competitive landscape.

Here’s how spread works in Forex trading in detail:

• Liquidity of the Currency Pair: Major currency pairs like EUR/USD are highly liquid and typically have lower spreads. Less liquid currency pairs, like exotic currencies, often have higher Forex spreads.
• Market Volatility: During periods of high volatility, Forex spreads can widen as the uncertainty increases the risk for the broker. Conversely, in stable market conditions, spread in Forex can be narrower.
• Broker’s Business Model: Brokers either have a dealing desk (market makers) or offer direct market access (no dealing desk). Market makers set their own Forex spreads, often slightly wider, to ensure profitability. No dealing desk brokers typically offer narrower spreads and charge a commission or rely on volume-based pricing.
• Costs and Risks: Brokers consider operational costs in Forex pricing, including technology, staff, and compliance expenses. They also account for the risk associated with holding positions, especially in fast-moving or unstable markets.
• Competitive Landscape: Brokers also adjust their spreads based on what competitors are offering to remain attractive to traders.

Where do Forex brokers create the prices for the spread?

Forex brokers obtain the prices from which the spread in Forex is derived through a process that involves several key participants and steps.

Primarily, these prices are sourced from liquidity providers, which are typically banks and other non-bank financial institutions operating in the institutional Forex market. These institutions, known as liquidity providers (LPs), form a liquidity pool, offering the prices for various currency pairs.

A Forex broker’s price for a given currency pair comprises two different quotes: the bid and the ask price. The bid price is the lower price at which a trader can sell, and the ask price is the higher price at which a trader can buy.

The broker receives a stream of prices from multiple liquidity providers and uses a pricing engine to aggregate these prices in real-time, finding the best available bid ask spread for each currency pair.

Notably, these bid and ask prices might not necessarily come from the same liquidity provider.

How to calculate spread in Forex trading?

The spread in Forex is calculated by subtracting the bid price from the ask price. It’s usually represented in pips, which are the smallest unit of price movement for a currency pair.

For most currency pairs, a pip is 0.0001 of the quoted price. In currency pairs involving the Japanese Yen, a pip is 0.01 due to the Yen’s lower value compared to other major currencies.

Example 1:

Currency Pair: EUR/USD

Bid Price: 1.1050

Ask Price: 1.1052

To calculate the Forex spread:

Spread = Ask Price – Bid Price

= 1.1052 – 1.1050

= 0.0002 or 2 pips

Example 2:

Currency Pair: USD/JPY

Bid Price: 110.25

Ask Price: 110.28

To calculate the Forex spread:

Spread = Ask Price – Bid Price

= 110.28 – 110.25

= 0.03 or 3 pips

In these examples, the bid ask spread for EUR/USD is 2 pips, and for USD/JPY, it’s 3 pips. The cost of the trade will be equivalent to the spread in Forex.

What are the types of spread in Forex trading?

In the Forex market, there are two primary types of spreads: fixed and variable.

Fixed spreads remain constant regardless of market conditions, offering predictability. Variable spreads fluctuate based on market volatility and liquidity, potentially offering lower costs but with added unpredictability.

Fixed spreads

Fixed Forex spreads refer to a predetermined difference between the bid and ask prices of a currency pair that remains constant under normal market conditions.

Fixed spreads do not fluctuate with market movements, providing Forex traders with a stable and predictable cost of executing trades. The characteristics of fixed spreads include their consistency, as they remain unchanged regardless of market volatility.

However, it’s important to note that fixed spreads are usually higher than variable Forex spreads because brokers typically set them at a higher level to compensate for the certainty and predictability offered by fixed spreads.

This higher cost helps brokers manage potential risks associated with market volatility and ensures that they can maintain a consistent profit margin, even during times of increased uncertainty or rapid price fluctuations.

Pros and cons of fixed spread in Forex trading?

Pros:

• More stability: Provides consistent pricing, ensuring predictability in trade execution and minimizing unexpected cost variations.
• Spreads are always the same: Fixed spreads remain constant, offering Forex traders assurance regarding transaction costs in different market conditions.

Cons:

• Spreads are higher than normal: Fixed spreads tend to be elevated compared to variable spreads, potentially leading to increased trading costs.

Variable spreads

Variable Forex spreads are a type of spread in Forex that can fluctuate based on market conditions. The Forex spread widens or narrows in response to changes in liquidity, volatility, and other factors affecting the foreign exchange market.

This type of Forex spread is the most common due to its dynamic nature, adjusting to the ever-changing conditions of the Forex market. Variable spreads are generally lower than fixed spreads during normal market conditions, making them more cost-effective for Forex traders.

Pros and cons of variable spread in Forex trading?

Pros:

• Lower spreads: Variable Forex spreads adapt to market conditions, offering cost-effective trading with narrower bid-ask spread.
• Higher liquidity: Variable Forex spreads often correlate with increased market liquidity, facilitating smoother trade execution.

Cons:

• Spreads can change rapidly: During periods of low liquidity or high volatility, variable Forex spreads may peak, increasing trading costs.

Forex Fixed spread vs Variable spread comparison

What’s the difference between spread and commission in Forex trading?

Spread-based and commission-based are two distinct Forex broker models. Spread-based brokers earn from the bid ask spread, while commission-based brokers charge a fixed fee per trade. Each model represents a different approach to how traders pay for brokerage services.

Forex brokers with a spread-based model profit by adding a markup to the Forex spread, widening it. Conversely, commission-based brokers earn through a fixed commission on trades, without markup on the spread.

Choosing between a spread-only or commission-based pricing model depends on a trader’s preferences and trading style. Forex traders who execute high-frequency trades may prefer a commission-based model, as it allows for transparent and potentially lower transaction costs. On the contrary, those engaged in longer-term trades might prioritize brokers with tight spreads to minimize costs over time.

What is a good spread in Forex trading?

For major Forex currencies, spreads below 1 pip are generally considered good by traders.

However, defining a “good spread” varies by the currency pair.

A spread of 2 pips on the AUD/SGD might be considered good due to its inherently higher volatility, while the same spread on the EUR/USD could be deemed less favorable given its liquidity and lower volatility.

Factors like volatility and liquidity play a role in Forex pricing. This leads us to explore why spreads vary in the Forex market, examining the dynamic influences shaping these fluctuations.

Why do spreads vary in Forex trading?

Trading Forex, spreads can vary depending on several factors. Some of the main ones include:

• Economic news release
• Currency pairs
• Time of the day
• Forex broker pricing

Below, we will delve into the specifics of what causes spreads to vary while trading Forex.

Why do spreads vary during economic news releases?

During economic news releases, spreads can vary widely due to increased volatility and uncertainty in the Forex market. This leads to higher risk, which prompts liquidity providers to widen Forex spreads to mitigate potential losses. Essentially, the rapid influx of information during these events affects market dynamics, altering supply and demand.

During major economic announcements like interest rate decisions, employment reports, or GDP data, markets can experience significant movements. These announcements often bring new information that can drastically change market expectations and valuations.

As a result, liquidity providers, including banks and other financial institutions, become more cautious in their trading, widening the Forex spread to protect against potential losses from rapid price movements.

Additionally, during these times, the number of market participants willing to trade can decrease, further contributing to wider spreads. The effect is more pronounced in markets with lower liquidity or during events with unexpectedly significant news.

Why do spreads vary between different currency pairs?

Spreads between different currency pairs vary mainly due to liquidity and market volatility.

For instance, highly traded currencies, like the US dollar or Euro, typically have narrower spreads because of their high liquidity and stable demand. Less commonly traded currencies like the Singaporean Dollar face wider spreads as their lower liquidity and demand lead to higher risks and costs for currency exchanges.

Market volatility also plays a crucial role. In times of economic uncertainty or geopolitical tensions, even commonly traded currencies can experience wider spreads. This is because uncertainty increases the risk of currency value fluctuations, prompting dealers to widen spread in Forex to mitigate potential losses.

Additionally, central bank policies and interest rate differentials between countries can influence currency spreads. When a country’s central bank changes its monetary policy or interest rates diverge significantly from those of other countries, it can lead to increased volatility and wider spreads for that country’s currency.

Why do spreads vary between different times of the day?

Spreads vary throughout the day due to fluctuations in market liquidity and trading volume. During peak trading hours, higher liquidity often results in narrower spreads as more buyers and sellers are active. Conversely, in off-peak times, reduced trading activity can lead to wider spreads.

The concept of Forex spread is closely tied to the dynamics of supply and demand in financial markets. During regular market hours, especially when major markets overlap, there’s a surge in trading activity. This increased activity boosts liquidity, enabling easier transactions at closer bid-ask prices, thus narrowing the spread. Key financial announcements or market events can further intensify trading, temporarily affecting Forex spread width.

In contrast, during off-hours, such as late nights or weekends for certain markets, trading volume drops significantly. With fewer market participants, the gap between the price a buyer is willing to pay and the price a seller is willing to accept widens. This widening of spreads reflects the increased risk and reduced certainty in price during these periods.

Why do spreads vary between Forex brokers?

Forex spread varies between brokers due to factors like liquidity, risk management strategies, and brokerage business models.

The best Forex brokers have access to larger liquidity pools, enabling tighter spreads, while others might widen spreads to mitigate risks or increase profits.

Brokers also differ in their operational setups and target clientele. High-volume trader-focused brokers like IC Markets offer narrower spreads with a commission model, while those targeting casual traders, like eToro, use a spread-based model without extra commissions, leading to wider spreads.

Lastly, brokers’ relationships with liquidity providers and their ability to aggregate quotes from multiple sources can impact the spread. A broker’s ability to secure competitive quotes from these providers depends on the strength of their relationships and their negotiating power. Brokers with strong, established connections to multiple liquidity providers can access a wider range of quotes. This ability to aggregate quotes means they can offer their clients more competitive, tighter spreads.

How does the spread affect my trading costs?

A wider spread means higher costs for traders, as they pay more when buying and receive less when selling, reducing potential profits.

In markets with high liquidity, where there are many buyers and sellers, the spread tends to be narrower. This reduces Forex trading costs, making it more efficient to enter and exit positions.

Conversely, in less liquid markets, the spread is wider, increasing the cost of trading.

Can I reduce spread in Forex trading?

Reducing spreads in Forex trading is possible, often through rebates, which are typically accessible to professional traders or those who trade in high volumes.

This is because brokers are more likely to offer rebates to traders who generate more trading activity, which in turn can increase the broker’s revenue.

Rebates are essentially a form of cashback or discount that traders receive after completing a Forex trade, and they are often offered by brokers as an incentive or reward.

For retail or individual traders, accessing such rebates might be more challenging. They may need to meet certain criteria set by the brokers, such as maintaining a minimum account balance or trading a specified volume.

Does leverage influence spreads in Forex trading?

Leverage doesn’t directly influence spreads, which are the differences between buying and selling prices of currency pairs.

However, using excessive leverage relative to high trading volumes can lead to liquidity issues. This results in requotes, where brokers adjust prices due to market conditions, adding indirect costs for traders.

Essentially, while leverage itself doesn’t change spreads, its misuse in high-volume scenarios can create conditions that indirectly increase trading costs through requotes and decreased market liquidity.

What are the lowest spread Forex brokers?

The best low spread Forex brokers are Pepperstone, IC Markets, and XM.

Low spread Forex brokers, offering raw spreads that often start as low as 0.0 pips, compensate for these tight spreads by charging a fixed fee commission per lot.

The table below illustrates the average spread levels for major currency pairs, offering insights into typical currency markets conditions.

This approach allows traders to benefit from narrower spreads while the brokers maintain their profitability through commission fees.

Are there zero-spread Forex brokers?

Zero-spread Forex brokers do exist, but this doesn’t mean the spreads offered are always zero in a literal sense.

Instead, these brokers offer variable spreads starting from 0 pips, which means the spread can vary and potentially be higher based on market conditions.

For example, a broker might advertise a spread “from 0 pips” on a major currency pair like EUR/USD. In this case, during highly liquid market hours, the spread might indeed be zero or swinging from 0 pips to 0.2 pips.

However, during times of low liquidity or high market volatility, such as economic announcements, the spread can widen significantly.

What trading strategies are most affected by spreads?

All trading strategies are influenced by the spread, but fast-paced ones like scalping are particularly impacted.

In scalping, traders aim to make profits from small price changes, often entering and exiting trades within minutes or even seconds. For scalpers, even a slightly wider spread can significantly reduce their profit margins, as they operate on very thin profit targets. Since they make a large number of trades, the cumulative cost of the spread becomes substantial.

This is why a low spread is crucial for the viability of scalping strategies. Brokers with higher spreads can make scalping unprofitable, as the cost of entering and exiting trades eats into the small gains that scalpers aim for.

What is spread betting?

Spread betting is a financial derivative strategy where participants speculate on the price movement of an asset, such as stocks or currencies, without actually owning the underlying asset. Profits or losses in spread betting are determined by the accuracy of the bet relative to the market movement.

Spread betting brokers are not allowed to offer services within the European Union and Australia due to regulatory restrictions. However, this form of trading Forex is quite prevalent in the UK and other parts of the world, where it remains a popular tax-effective method for traders to engage in the financial markets without the need for direct asset acquisition.