What is a Spread in Forex?

No forex trade is free. Many forex brokers charge commissions for each trade, but there is a silent cost that also impacts your forex profits. Spreads represent an extra expense for each trade. It’s the difference between the bid price and the ask price. This guide will explore how forex spreads work and how traders can profit despite spreads.

How Do Forex Spreads Work?

A forex spread is the difference between the bid and ask prices. The bid price shows how much you will receive if you sell an asset, while the ask price shows how much you have to pay to obtain an asset. The ask price is always higher than the bid price. That means you pay the higher amount to buy an asset and receive the lower amount when you sell the same asset.

You can still profit from forex trading if you hold an asset long enough for the bid and ask prices to move in your favor. However, if you buy and sell a forex position within a microsecond, you will get burned by the spread, especially if there is a big gap between the bid price and the ask price. 

Types of Forex Spreads

Every forex spread is either a fixed spread or a variable spread. Here’s how these types of forex spreads work. 

Fixed Spreads

Fixed spreads preserve the same difference between the bid price and the ask price regardless of how much an asset moves. For instance, if a fixed spread is $0.01, you will pay that same difference even if the asset doubles in value. Fixed spreads are more favorable for assets that continue to rally.

Variable Spreads

Variable spreads fluctuate based on market conditions. These spreads can get wider due to heightened market volatility and lower liquidity. However, traders will end up with low spreads during market cycles that feature high liquidity and low volatility.  

Comparing Fixed vs. Variable Spreads

With a fixed spread, you’ll know the cost of each trade regardless of when you place it. If the spread is $0.05 today, it will be $0.05 tomorrow. Variable spreads aren’t static and will fluctuate based on market conditions. A variable spread may be $0.05 today but then $0.06 tomorrow. It can drop down to $0.04 the following day if there’s more liquidity and less volatility.

Bid-ask spreads are higher for assets that don’t receive as much attention. However, most traders prefer variable spreads since the cost of trading is lower during periods of high liquidity. Variable spreads reward forex traders who have a better understanding of current market conditions and specific currency pairs. 

Fixed spreads are simpler but not as rewarding for traders. However, they are more predictable than variable spreads. Some traders get stuck with variable spreads that widen dramatically shortly after they have entered the position. In this case, it becomes more difficult to realize a positive return on a variable spread than a fixed spread.

Calculating Forex Spreads

You just have to deduct the bid price from the ask price. For instance, if an asset has a $1.20 bid price and a $1.22 ask price, the spread is $0.02. 

In this case, you have to buy the asset for $1.22 and sell it for $1.20. However, if you give it time, the asset may gain value and present a more favorable exit price. That’s why traders have to wait a bit before they can rush to sell a position.

Forex traders use the term “pips” to describe forex spreads. Each pip is 0.0001 for most currency pairs. However, if you are using USD/JPY, a single pip is 0.01. A 0.02 spread is 200 pips.  

Factors Influencing Forex Spreads

A few factors influence the forex spreads you’ll see when it’s time to trade. Here’s what to consider when starting positions in various currency pairs.

Market Volatility

High volatility will lead to wider bid-ask spreads. Sharp price movements increase uncertainty and result in higher spreads. Market makers may also have to increase spreads since volatility makes it more difficult to hedge their positions. Market volatility can also decrease liquidity, another factor that will result in wider spreads. 

Currency Pairs

Each asset has different levels of volatility and liquidity. Highly liquid pairs like EUR/USD have low spreads since they don’t come with as much volatility. Currency pairs with less liquidity end up with higher spreads. For instance, EUR/ZAR doesn’t see much trading activity, resulting in less favorable spreads for traders.

Market Session Timing

The time of the day will also affect spreads since the market is more active during some forex trading hours and days than others. Spreads are tighter when there are more market participants and financial markets greet the most participants from 8 a.m. to noon Eastern. That’s the overlap between the New York and London market sessions. Tuesday, Wednesday and Thursday also have lower spreads than Mondays and Fridays. 

Economic Announcements and Events

Economic announcements and events can increase volatility, which leads to wider spreads. Market participants may wait for a big announcement on inflation or recent unemployment numbers before making their trading decisions. This uncertainty results in higher spreads. If the market is calm without any groundbreaking events or announcements on the way, spreads usually tighten.

Additional Influences on Forex Spreads

While the key factors have already been discussed, these are some of the additional forces that determine bid-ask spreads.

• Slippage and its effects: Slippage occurs when an order is filled at a price different from what was expected. This can happen when you initiate a market order on a volatile asset. Slippage can signal high volatility and low liquidity, which may widen the bid-ask spread.
• Role of forex brokers: Brokers can add a markup to raw spreads to boost their profits. However, forex brokers face plenty of competition from each other, which limits how much they can widen the bid-ask spreads.
• Impact of commissions: Commissions increase the cost of trading, which will minimize your profits. While some brokers have upfront commissions, other brokerage firms slip commissions into the bid-ask spreads, resulting in hidden trading costs.

Understanding Raw vs. Spread-Only Pricing

Raw spreads are what you get if you have direct access to interbanks. It doesn’t have any broker’s markup fee. Brokers typically charge a commission for each trade if they give you access to raw spreads. 

Spread-only pricing is more common. It’s when a broker tacks on a small fee on top of the bid-ask spread. With spread-only pricing, all of the fees are included in the spread. While active traders usually prefer raw spreads, these types of spreads have a greater quantity of fees. You have to stay on top of the spread and a broker’s commission.

Managing Forex Spreads

Understanding how forex spreads work can help traders minimize their losses and enter profitable positions. Spreads widen during cycles with high volatility and low liquidity and spreads also vary for each asset. Currency pairs like EUR/USD have low spreads since they are extremely popular among traders and investors. Less popular currency pairs will have higher spreads.

Frequently Asked Questions