The Definition of Spread in Forex Trading
The spread is an unseen expense in foreign exchange trading, which is basically purchasing one currency and selling another. You may not have realized it, but if you have ever exchanged money while traveling overseas, you are familiar with spreads. Spreads function similarly and are important to successful forex trading.
In India, many brokers advertise “zero commission” trading, but spreads are how they make money behind the scenes. By comprehending the workings of a spread, its impact on your transactions, and its definition, you can prevent unexpected expenses.
What Is a Spread in Forex Trading?
Ever wonder how “no commission” brokers make money? It’s through the spread. In forex trading, the spread is the fee for providing instant transactions. It’s the difference between the bid price, which is the price buyers are willing to pay, and the ask price, which is the price sellers are willing to sell.
For a brief example, you stop by the currency exchange booth at the airport. They’ll buy your dollars at a lower price and sell you a rupee at a higher price. That price gap is the spread.
This is why traders often call the spread a “transaction cost.” You’re paying for the convenience of executing trades instantly without waiting for a perfect buyer or seller.
How to Calculate Spread in Forex
Calculating the spread in forex trading is simple and straightforward. The spread is the difference between the bid and ask prices of a currency pair, measured in pips—the smallest price change in forex. This is your transaction cost, even if your broker says there’s “no commission.”
In forex terminology, always remember the structure of a currency pair:
- The base currency appears first (e.g., USD in USD/INR)
- The quote currency comes second (e.g., INR in USD/INR)
Use the USD/INR pair = 83.4520/83.4570 as an example. The spread will be calculated as:
Spread = Ask Price – Bid Price
= 83.4570 – 83.4520
= 0.0050 or 5 pips
In this case, the spread for this USD/INR is 5 pips, which represents the cost of the transaction for the trader.
Tip: A pip is typically the last decimal place of price quote for most currency pairs. However, for the currency pairs involving the Japanese Yen (JPY), a pip is measured at the 2nd decimal place (0.01).
Types of Spread in Forex
There are two main types of spreads used in foreign exchange trading: fixed spreads and floating spreads. Spreads are different depending on your broker’s price model and the condition of the market.
Fixed Spread
A fixed spread stays the same regardless of market conditions. Brokers using this model typically act as market makers, meaning they set their own prices.
Features of Fixed Spreads:
- Fixed spreads do not change during market volatility.
- Easier to predict trading costs, especially for beginners.
- Ideal for low-volatility trading or scalping.
Pros:
- Stable costs, even in volatile markets.
- Suitable for traders with smaller capital.
Cons:
- May have wider spreads compared to floating ones during calm markets.
- Limited transparency in execution during high volatility.
- Increased chances of slippage when prices are moving uncontrollably.
- With only one source for pricing, traders may experience frequent requotes.
Floating Spread
A floating spread changes dynamically based on market conditions, such as liquidity and volatility. Brokers offering this model connect traders directly to the interbank forex market.
Features of Floating Spreads:
- Tight spreads during calm markets, sometimes as low as 0.1 pips.
- Spreads can widen significantly during volatility or low liquidity.
- Ideal for experienced traders who need a cost efficiency option.
Pros:
- Lower costs during stable market conditions.
- More transparent pricing linked to real market liquidity.
Cons:
- Unpredictable costs during volatility.
- It’s not ideal for beginner traders.
What Determines the Spread in Forex?
The spread in forex trading isn’t random—it’s influenced by several factors that brokers and market conditions dictate.
1. Market Liquidity
Liquidity represents how actively a currency pair is being traded. When a market is highly liquid, like EUR/USD or USD/INR, there’s plenty of buying and selling, which results in tighter spreads. Conversely, minor currency pairs like INR/ZAR or USD/THB, which have fewer participants, face wider spreads because brokers compensate for the risk of low liquidity.
2. Market Volatility
High market volatility widens spreads. This occurs when major economic events like RBI or Fed interest rate decisions trigger price fluctuations. Brokers raise spreads to minimize massive, erratic transactions during these occurrences.
3. Time of Day
Market activity in the foreign exchange fluctuates throughout the day and night. Spreads are narrowest when the New York and London trading periods overlap since liquidity is at its highest then. Conversely, spreads widen when liquidity drops during calmer times, such as the late hours of the Indian night (Sydney and Tokyo sessions).
4. Type of Brokers
The function of brokers plays an important role for setting spreads. Fixed spreads offered by brokers remain consistent regardless of market volatility; however, this may result in slippage or requotes. Conversely, floating spreads offered by ECN (Electronic Communication Network) brokers tend to be narrower during stable market times and riskier during volatile ones.
5. Currency Pair Characteristics
Due to their massive trading volume and consistent demand, major pairings such as EUR/USD or USD/INR have narrower spreads. Because of the increased volatility and reduced market activity, minor pairings such as INR/JPY or GBP/THB typically have wider spreads.
6. Economic Events
Public announcements of major economic events, such as inflation rates, jobless states, or unstable politics, have the potential to increase volatility and widen spreads. An unforeseen statement from the RBI could cause the USD/INR spread to spike suddenly.
Spread Costs
Spread costs in forex trading are like hidden service charges—they can’t be avoided but can be managed. There are two metrics that traders need to understand to determine how much money they gain or lose per pip movement. Those are pip value and lot size.
Pip value tells you the monetary worth of one pip in a currency trade.
Lot size is the trade volume or the number of currency units you’re buying or selling. Lot sizes come in three common types:
- Standard Lot: 100,000 units (Pip value = $10)
- Mini Lot: 10,000 units (Pip value = $1)
- Micro Lot: 1,000 units (Pip value = $0.10)
Formula and Example Calculation
Spread Cost = Spread (in Pips) x Lot Size x Pip Value
Ex. You’re trading USD/INR, and the broker shows a bid/ask quote of 83.4520 / 83.4570. You decide to trade in 1 standard lot (100,000 units).
As we mentioned before, the value of 1 pip is typically $10 per pip for 1 standard lot in USD/INR.
Spread Cost = 5 × 1 × 10 = $50
For this example, if the spread is 3 pips and you’re trading 1 standard lot, then your transaction cost is $30.
Conclusion
Understanding the spread is crucial for managing your trading costs in the forex market. Whether you’re dealing with fixed or floating spreads, knowing how they are calculated—and what influences them—can help you make more informed trading decisions. By being aware of factors like market sessions, liquidity, and lot size, traders can better plan entries and exits. Ultimately, mastering the concept of spreads is a foundational step toward trading more efficiently and profitably.
To turn these knowledge into actionable trading strategies, a deeper insight into forex trading concepts, techniques, and market analysis is necessary. Our Forex Trading Terms is committed to helping traders and investors who require assistance.
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Disclaimer
Forex trading involves risk. Indian residents should trade with regulated platforms and follow RBI guidelines for INR-based currency pairs. This content is for educational purposes only.
FAQs
A spread in forex is the difference between the bid price and the ask price of a currency pair. It’s the broker’s fee for executing your trade, often measured in pips.
Spreads are higher at night because of low market liquidity. During this time, major financial markets like London and New York are closed, meaning fewer traders are active. With less buying and selling, brokers increase spreads to cover the risk of price fluctuations.
A good spread in forex is typically 1-3 pips for major currency pairs like EUR/USD or USD/INR during active trading hours. Spreads below 1 pip are considered excellent, especially for scalpers or day traders.
Low spreads are essential because they reduce trading costs, allowing traders to enter and exit positions more efficiently. With tighter spreads, your trade becomes profitable faster since you don’t need the market to move significantly to cover the cost of the spread.
You can avoid high spreads by trading during peak market hours, such as the London-New York session overlap, when liquidity is highest. Choose brokers with tight spreads and avoid trading around major news events, when spreads tend to widen due to volatility. Consider trading major currency pairs with naturally lower spreads.