The main points to understand forex spreads are:
- Spreads depend on the buying and selling price of a currency pair.
- The cost of trading is determined by the forex spread and the size of the trade.
- Forex spreads can change over time and you should check them on your trading platform.
Knowing how forex spreads work is crucial for traders who want to succeed in the currency market. In this article, we will show you how to calculate the cost of trading, and how to monitor the changes in the spread to optimize your trading results.
HOW DO YOU MEASURE THE SPREAD IN FOREX TRADING?
The spread is the difference between the price at which you can buy or sell a currency pair in the forex market. This is similar to the concept of the Bid: Ask spread in stocks.
We can see an example of how to calculate the forex spread for the EUR/USD below. First, we take the buy price of 1.13398 and then we subtract the sell price of 1.3404. The result of this calculation is .00006. We should note that the pip value for the EUR/USD is the 4th digit after the decimal point, which means that the final spread is 0.6 pips.
Next, let’s see how much money traders have to pay for the spread in pips.
HOW TO WORK OUT THE FOREX SPREAD AND COSTS?
The spread is the difference between the ask price and the bid price of a currency pair. So, in our example above, 1.13404-1.13398 = 0.00006 or 0.6 pips.
Using these quotes, we know we can buy the EUR/USD at 1.13404 and sell it at 1.13398. This means that as soon as we open our trade, we would have to pay 0.6 pips of spread.
To get the total spread cost, we need to multiply this value by the pip cost and the number of lots traded. When trading a 10k EUR/USD lot, the total cost would be 0.00006 (0.6pips) X 10,000 (10k lot) = $0.6. If you were trading a standard lot (100,000 units of currency) your spread cost would be 0.00006pips (0.6pips) X 100,000 (1 standard lot) = $6.
If your account is in another currency, like GBP, you would have to change it to US Dollars.
HOW THE SPREAD CAN CHANGE THROUGHOUT THE DAY?
It’s important to remember that the FX spread can change during the day, from a ‘high spread’ to a ‘low spread’.
This is because the spread can be affected by different factors like volatility or liquidity. You will see that some currency pairs, like emerging market currency pairs, have a bigger spread than major currency pairs. Your major currency pairs have more trading volume than emerging market currencies, and higher trading volume usually leads to lower spreads in normal conditions.
Also, it’s well known that liquidity can decrease and spreads can increase before major news events and between trading sessions.
High spread
A high spread means the bid and the ask price are far apart. Emerging market currency pairs usually have a high spread compared to major currency pairs.
A higher than normal spread usually means one of two things, high volatility in the market or low liquidity due to trading outside of normal hours. Before news events, or during big shock (Brexit, US Elections), spreads can increase a lot.
Low spread
A low spread means the bid and the ask price are close together. It is better to trade when spreads are low like during the major forex sessions. A low spread generally means that volatility is low and liquidity is high.
HOW TO MONITOR THE CHANGES IN THE SPREAD?
News is a well-known source of market uncertainty. Events on the economic calendar occur randomly and depending on whether expectations are met or not, can cause prices to move quickly. Just like retail traders, large liquidity providers do not know the outcome of news events before they happen! Because of this, they try to reduce some of their risk by increasing spreads.
Spreads can trigger margin calls
If you have an open position and the spread becomes very wide, you may be stopped out of your position or receive a margin call. The only way to protect yourself during times of increasing spreads is to limit the amount of leverage used in your account. It is also sometimes helpful to hold onto a trade during times of spread-increasing until the spread has narrowed.
For more tips on how to trade successfully with the forex spread, take a look at our recommended forex spread trading strategies.
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