What Does a Forex Spread Tell Traders?

[ad_1]

Forex spreads explained: Main talking points

Spreads are based on the bid and ask prices of the currency pair.
Costs are based on forex spreads and lot sizes.
Forex spreads are variable and should be referenced by your trading platform.

It is important for traders to be familiar with forex spreads as they are the main cost of trading currencies. In this article, we’ll explore how forex spreads work and how to calculate costs and monitor spread changes to maximize your trading success.

What is a spread in forex trading?

Every market has spreads, and so does Forex. The spread is simply defined as the price difference between a trader buying or selling the underlying asset. Traders familiar with stocks refer to this as the bid-ask spread.

Below we see an example of a Forex spread calculated for EUR/USD. First we find the bid price at 1.13398 and then subtract the ask price at 1.3404. What remains after this process is a reading of 0.00006. Traders should note that the pip value is expressed in EUR/USD to the 4th decimal place, resulting in a final spread of 0.6 pips.

Now that we know how to calculate the spread, let’s look at the actual cost incurred by the trader.

How to calculate the forex spread and costs

Before we calculate the cost of the spread, remember that the spread is simply the ask price minus (minus) the bid price of a currency pair. So in our example above, 1.13404-1.13398 = 0.00006 or 0.6 points.

From the above quotes we know that we can currently buy EUR/USD at 1.13404 and close the trade at the ask price of 1.13398. This means that once our trade is open, traders will have a spread of 0.6 pips.

To find the total spread cost, we now need to multiply this value by the pip cost, taking into account the total lot size of the trade. Trading 10,000 lots of EUR/USD would result in a total cost of 0.00006 (0.6 pips) x 10,000 (10,000 lots) = $0.6. If you trade 1 standard lot (100,000 currency units), your spread cost will be 0.00006 pips (0.6 pips) x 100,000 (1 standard lot) = $6.

If your account is denominated in another currency (eg GBP), you will need to convert it to USD.

Understanding a high spread and a low spread

It is important to note that forex spreads may vary throughout the day, between “high spreads” and “low spreads”.

This is because spreads can be affected by a variety of factors such as volatility or liquidity. You’ll find some currency pairs, such as emerging market pairs, have wider spreads than major currency pairs. Compared to emerging market currencies, their major pairs have higher trading volumes, which in normal times tend to result in lower spreads.

Additionally, liquidity is known to dry up before major news events and between trading sessions, and spreads can widen.

High spread

A high spread means that there is a big difference between the bid and ask prices. Emerging market currency pairs often have large spreads relative to major currency pairs.

Higher-than-normal spreads usually indicate one of two things: high market volatility or low liquidity due to after-hours trading. Spreads can widen sharply during news events or major shocks (Brexit, US election).

Low spread

Low spreads mean that the difference between the bid and ask prices is small. It is best to trade when the spreads are low, such as during large forex trading sessions. Low spreads usually indicate low volatility and high liquidity.

Keeping an eye on changes in the spread

News is a notorious time for market uncertainty. Releases in the economic calendar are sporadic, and prices can fluctuate rapidly depending on whether expectations are met. Just like retailers, large liquidity providers don’t know their results until news events are released! Therefore, they try to offset some of the risk by widening the spread.

Spreads can cause margin calls

If you currently hold a position and the spreads widen sharply, you may be stopped out of the position or receive a margin call. The only way to protect yourself during a widening spread is to limit the leverage used in your account. It is also sometimes beneficial to hold trades during periods of widening spreads until the spreads tighten.

For more tips on successfully navigating forex spreads, check out our recommended forex spread betting strategies.