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Forex spreads: what it is and how it works

Spread is one of the most basic terms in stock trading and investing. This term is very familiar to traders in the forex market. But if you are a new trader, you need to understand what the spreads are to be successful. This article will learn what forex spreads are, their importance, how they are calculated and more.

What are spreads in Forex? What is the Bid-Ask spread?

Before learning how to calculate spreads and understand their importance in stocks, traders need to understand what spreads are?

In the Forex market, the spread is the difference between bid and ask prices.

In other words, the forex spread represents the difference between the bid and demand prices (Bid and Ask) of a given financial asset.

The selling price is always higher than the purchase price. Therefore, if a trader opens a trading position and then closes it immediately, the trader will surely lose a loss equal to the spread.

Therefore, when opening a trading order, traders have to wait for the market to move in the desired direction with an amount equal to the spread or greater for profit.

In addition to commissions and swaps, the spread is also one of the main sources of income for brokers. Spreads or spreads can be fixed or floating, but often online exchanges offer floating spreads.

Forex and Pip Spreads

The difference in spread between bid and ask prices is expressed in “pips” or “points”. A pip is the 4th decimal place in the currency market after the full part of the exchange rate (with the exception of the Japanese yen, which has only two decimal places), and the Forex spread is measured in pips.

Suppose the GPB/USD currency pair is trading at 1.29300/1.29310. The difference between the bid and ask prices here is 0.0001 – which equates to a spread of 1 pip.

Forex spreads change according to price movements and depend on each broker. The most traded currency pair is Euro vs US Dollar (EURUSD). Therefore, the spread of this currency pair is usually the lowest.

How to calculate the spread in Forex?

The Forex spread is measured in pips, so how can we calculate spreads based on the value of the currency.

The monetary value of the spread depends on the trading volume, as the trading volume determines the size of each pip.

In Forex, the formula for calculating the value of one pip of the quote currency (2nd currency in the currency pair) is 0.0001 multiplied by the trading volume.

Example of how to calculate the Spread in Forex.

When trading a lot of GPB/USD, we have:

  • 1 lot GPB/USD = 100,000 GBP
  • Value of 1 pip GPB/USD = 100,000 x 0.0001 Unit of valuation (USD) = 10 USD

Put, for all currency pairs (except the Japanese yen), the value of 1 pip of 1 lot traded will be ten units of the quote currency. As in the example above, the value of 1 pip of 1 lot of GPB/USD is 10 USD.

For currency pairs with the quote currency of the Japanese yen, the pip will be the 2nd decimal place after the full part of the exchange rate. This means that we will multiply the trading volume by 0.01 instead of 0.0001 as the original formula.

Based on the previous example, when we calculate the spread of one pip, we can say that the spread commission of 1 lot traded is 10 USD.

What are the factors that affect forex spreads?

The spread is influenced by the following factors:

  • Liquidity of financial assets
  • Market conditions
  • The volume of financial assets traded

Spreads depend on the liquidity of financial assets. The more assets are traded, the more liquid the market is. This means that the narrower the gap between supply and demand, the smaller the spread. In low-liquidity, less-traded markets like natural gas, spreads are often higher.

The spread can change depending on market conditions: it is usually higher when macroeconomic information is released or when the market is volatile.

If a trader trades when the Federal Reserve or the European Central Bank has a press conference, making important economic statements, the spread is usually higher.

Some brokers offer fixed spreads. But when economic events or volatile markets are announced, most brokers cannot guarantee a fixed spread.

Trading volume also affects the spread. If a trader’s trade is so large that it causes the market to move in the opposite direction, market makers need to adjust the spread to compensate for the increased risk they are taking. However, the reality is that the forex market is so liquid that it is difficult for a retail trader to influence the market price.

The importance of forex spreads

To become a successful Forex trader, traders need to find the most suitable trading strategy for them. A trader can accept spreads depending on the trading style and technique he chooses.

For day traders to use the scalper strategy, the spread plays a vital role. These traders participate in the market many times a day. If the spread is high, their profits can be severely affected.

The longer the trading time period, the smaller the effect of the spread on the profit earned. For example, if a swing trader makes profits that accumulate in days, weeks or even months, the spreads affecting them are very low compared to the size of the movements in the markets in which they are trading on hold.

Traders who often enter and exit trades can see spreads add up quite a bit. Therefore, if this is the trading style that the trader is adopting, then the trader must place an order when the spread is optimal.

Conclusion

The Forex spread is the most fundamental concept in stock trading. Traders should worry about spreads, but how much they care about depends on the trader’s trading strategy.

The shorter the trading strategy, the more often it is traded, the more traders should pay attention to the spread. If you are a scalper or a day trader, the spread will significantly affect profits and losses. The lower the spreads, the higher the return.

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