What is Spread in Forex Trading & How it is Calculated?

It is important for traders to fully understand what is spread in forex trading. To maximize the trading success, further explored are concepts like how forex spreads operate as well as how to calculate costs and monitor fluctuations in a Forex spread.

What are Spreads in Forex?

The price difference between ask price and bid price of a currency pair is known as a spread in the forex. The size of the spread is affected by factors like market volatility and currency pairs that interest the traders. Spreads are typically wider in a volatile market. Therefore, the cost of transaction increases.

Types of Spreads in Forex

The choice between several types of spreads is the key consideration for traders when it comes to online forex trading . Following are the two main two types of spreads:

Fixed Spreads

Fixed spreads are predetermined before the traders place trades. It is offered by those who serve as the counterparty to the clients’ trades. The pros and cons of fixed spreads are as follows:

PROS

1. The major benefit of fixed spreads is that traders are always aware of the price of each trade. This ensures assurance and enables traders to plan their risk management strategies in advance. Additionally, fixed spreads are especially desirable in times of market volatility when variable spreads tend to get significantly wider.
2. Traders do not have to worry about requotes because fixed spreads remain constant. Requotes occur when a trader wants to enter or exit a trade at a price that is no longer available, which can cause delays or probable slippage. Fixed spreads allow traders to conduct their trades instantly and at the desired price.

CONS

1. Fixed spreads are higher compared to the variable spreads as market makers and desk brokers who offer these include their profit margin into the spread. This results in increasing the trading cost of traders.
2. Fixed spreads offer limited liquidity. Market makers provide fixed spreads by holding the opposite side of the trade placed by their clients. This may lead to slippage and delays in execution which are damaging for traders, particularly those trading huge volumes.

Variable Spreads

Variable spreads, commonly referred to as floating spreads, vary in response to the circumstances of the market. They are often provided by brokers that use an electronic communication network (ECN) or straight-through processing (STP) to link traders with the interbank market.

PROS

1. Variable spreads are competitive when market conditions are normal. ECN and STP brokers have traders connected directly to numerous liquidity providers, which results in tighter spreads. This also leads to lower cost of trading, especially for those who trade high volumes.
2. Since variable spreads are based on current market situations, allowing traders to have access to transparent pricing. They can also view the bid and ask prices along with the spread in real-time, resulting in a thorough market analysis before jumping to a strategy for trading.
3. Variable spreads provide enhanced liquidity as traders are connected to the interbank market. High liquidity allows faster and efficient trade execution minimizing the probability of slippage.

CONS

1. The major disadvantage of variable spreads is that they can significantly widen at times of high volatility in the market. If traders are not able to execute trades at the desired cost due to rapid movements of price in the market, this can increase the cost of trading.
2. Brokers who offer variable spreads may influence the prices in the market when there is low liquidity. This leads to slippage and delays in execution that negatively impacts the profitability of traders.

How to Calculate Spreads in Forex?

Basic Spread Calculation

It is important to have the knowledge of Ask Price and Bid Price before determining the spread. 

Ask Price: It refers to the lowest price at which a dealer will give away units of a currency for.  

Bid Price: It refers to the highest price at which a traders will buy units of a currency.  

The forex spread is presented as a percentage and can be calculated with the following formula: 

SPREAD% = [(Ask Price – Bid Price) /Ask Price] x 100

Factors Affecting Spread

Numerous factors can have a significant impact on spreads. Some of the primary factors are as follows: 

1. Liquidity: An asset is deemed liquid if it can be easily turned into cash. The spread would be lower and vice versa depending on how liquid the asset was.
2. Volatility: In times when there are economic events taking place, the forex market can move abruptly and be extremely volatile. This leads to forex spreads being extremely wide since exchange rates can fluctuate.
3. Time of the Day: The time of a trade's initiation is crucial as it affects liquidity. A lack of liquidity results in fewer traders, making it difficult to buy and sell the currency. Forex brokers widen their spreads to account for this risk.

Importance of Understanding Spreads in Forex

Impact on Trading Costs

The impact of spreads on trading costs is significant, as a wider spread implies a higher cost for entering and exiting positions. Traders aim to profit from price fluctuations, and the spread immediately affects their ability to do so. A larger spread means that the market must move more in favour of the trader before they can break even or make a profit. Consequently, traders often seek brokers offering tighter spreads to minimize their trading cost.

Risk Management

As spreads have a direct impact on the cost of trading and risk management strategies, it is important to understand the concept thoroughly. When traders can accurately determine spreads, they are able to calculate potential profits in a better way. This implies that the traders can start closer to breakeven, minimizing the need for price movements to be in their favour. In turn, this enhances risk management by allowing for smaller stop-loss orders and reducing the risk of slippage, helping traders make more informed and cost-effective trading decisions.

Tips for Minimizing Spread Costs

Choosing the Right Broker

Finding a broker that offers competitive spreads and minimal commissions is essential because trading costs significantly impact the profitability of the traders. The broker must stand out in terms of offering competitive pricing for forex trading. The broker must guarantee the traders that they can execute their transactions at the best rates, boosting their potential profits, with tight spreads and open commission structures.

Trading During Optimal Times

For optimal trading, choose hours with narrow spreads, usually during market overlaps. The best times include London-New York overlap (8 am to 12 pm EST) and London-Tokyo overlap (3 am to 4 am EST). These periods maximize liquidity, reducing spreads, and providing more favourable conditions for traders.

Conclusion

Due to a range of factors like liquidity, volatility, and market conditions, forex spreads may spiral out of control by the end of the day. Traders may mitigate the impact on profitability of these larger spreads by recognizing the cause and placing strategies in motion to deal with them. Traders can successfully traverse spreads and accomplish their trading objectives by emphasizing on trading during the most active and volatile times of the day, employing limit orders, and keeping up with market news and events.

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