What is a Spread in Forex Trading?

Trading in the forex market involves exchanging one currency for another at an agreed exchange rate. Because of this, each currency’s price is quoted in terms of its value against another currency. The forex spread, which is the difference between the price at which a broker sells a currency and the price at which the broker buys it, plays a crucial role in determining transaction costs for traders.

A currency pair displays two prices: the bid and the ask. The bid price is the rate at which you can sell the base currency. In contrast, the ask price is what you pay to buy the base currency. The spread is simply the difference between these two prices.

In a currency pair, the base currency appears on the left, and the quote currency appears on the right.

A currency quote shows how much of the second currency you need to buy one unit of the first currency. The real market price sits between the buy price and the sell price. The difference between them is the amount you pay to buy the currency.

The foreign currency market includes numerous participants, including forex brokers, individual investors, investment firms, financial institutions, and governments, with a daily trading volume of $7.5 trillion. This high trading activity has an impact on currency demand, exchange prices and the forex spread.

How forex spread works

Most currency pairs in forex trade without any commission. Instead, the spread becomes the cost of trading. In other words, every transaction must cover this cost. Forex brokers add the spread to each trade rather than charging a commission, which is why the ask price is always higher than the bid price.

Several factors influence the size of the spread. These include the currency pair you choose, its level of volatility, the amount of money you trade, and the broker you use. The EUR/USD, GBP/USD, USD/JPY and USD/CHF are some of the most popular major currency pairs.

Investors should monitor a broker’s spreads because every trade must earn enough to cover the spread and any extra fees. Each broker can also widen its spread, which increases its profit on each trade. When the bid-ask spread grows larger, traders pay more when buying and receive less when selling. As a result, different brokers may offer slightly different spreads, which can raise the overall cost of currency transactions.

How to quote spreads

Traders often quote the U.S. dollar and Canadian dollar as a pair (USD/CAD). In this pair, USD serves as the base currency, and CAD acts as the quote currency.

For instance, the currency pair USD/CAD would be equal to 1.2500/1 or 1.2500, if it cost $1.2500 (Canadian dollars) to buy $1 (U.S. dollars). The base currency would be the USD, and the quote or counter currency would be the CAD. In other words, because the conversion rate is given in Canadian dollars, one US dollar is equivalent to 1.25 C$. Traders often analyze this pricing structure along with the forex spread, as the spread directly affects the actual cost of entering or exiting such a trade.

Some currency pairs use the US dollar as the quoted currency. For example, if the British pound trades at 1.28 against the dollar, you will see a quoted price of $1.2800. In this pair, the pound acts as the base currency, and traders express the exchange rate as GBP/USD.

Depending on the currency involved, spreads might be tighter or wider. Usually, the gap between the two prices is 1-5 pips. However, depending on market conditions, the spread might fluctuate and change at any time.

Factors affecting the spread in Forex

Aside from the broker, additional factors could increase or reduce a forex spread.

Time the trade was placed

The time of day matters when you place a trade. For example, the European session begins early in the morning for US traders, while the Asian session opens late at night for both US and European investors. If you enter a euro trade during the Asian session, the spread will likely be much wider than it would be during European trading hours.

Put simply, there won’t be many traders trading that currency if it’s not the typical trading session, which results in a lack of liquidity. An illiquid market means that there aren’t many market participants which makes buying and selling of the currency harder. Forex brokers, therefore, raise their spreads to reflect the possibility of a loss if they are unable to exit their position.

Market events & volatility

Political and economic events can also widen FX spreads. For instance, if the U.S. unemployment rate came in much higher than anticipated, the dollar would most certainly weaken or lose value in comparison to the majority of currencies. When such events occur, the currency market may move quickly and become highly turbulent.

Due to the tremendous volatility of currency values during market events, forex spreads can become quite large. A forex broker may find it difficult to determine the true exchange rate during times of event-driven volatility, which forces them to charge a bigger spread to reflect the increased risk of losing money.

Pip spread in forex trading

The last decimal point on the price quotation (equivalent to 0.0001) and the smallest unit of movement in the currency pair price, are called pips which are used to calculate the spread. With the exception of the Japanese yen, where the pip is the second decimal point (0.01), the majority of currency pairs have this characteristic.

Wider spreads indicate higher price differences between the two prices, which typically translates to limited liquidity and high volatility. On the other side, a smaller spread denotes good liquidity and minimal volatility. Trading a currency pair with a tighter spread will consequently result in a lower spread cost.

The spread while trading forex can be either constant or variable. Since the spread for forex pairs is unpredictable, it fluctuates along with changes in the currency pair’s bid and ask prices.

Disclaimer:

This information is not considered investment advice or an investment recommendation, but instead a marketing communication. IronFX is not responsible for any data or information provided by third parties referenced or hyperlinked, in this communication.