No, we are not talking about a butter spread, but it wouldn’t hurt to have some of it while analysing the markets!
An FX spread will apply if you hold a position for a split second or a minute. Trading forex is like any business because it has transaction fees and other expenses. Fortunately, we don’t have many to deal with in this market besides currency spreads and swaps.
It’s a small cost of having the privilege to buy and sell pairs from the comfort of our homes using a modern charting platform. Although a spread in forex is usually insignificant, you should understand this topic quite well, particularly if you’re a scalper or day trader.
Without further ado, let’s explore the forex spread definition, how it’s calculated, what makes it change, and the ideal spread for successful trading.
What is the spread in forex? What do spreads mean in forex?
The spread in forex meaning is the difference between the bid (selling price) and ask (buying) price of a pair. This is why we sometimes call it the bid/ask spread in the financial markets.
The job of brokers is to collect spreads for each transaction that their clients execute.
They source the pairs usually from an external liquidity provider, but this may be done internally if the broker uses a dealing desk system.
The broker makes money by selling a pair for higher than they paid to buy it and derives profit from buying a pair for lower than they will receive for selling. The difference between each of these transactions is the forex spread.
Before you place an order in FX, you will typically see a screen that looks similar this with two prices:
The left side is the bid or selling price, while the right side is the ask or buying price. The difference (which we measure in pips) offers us the spread. Let’s go through what would happen if you clicked either of these two options.
If you pressed ‘SELL’ at 1.30855, your final order would be live at 1.30840 (1.5 pips lower than the initial price).
Conversely, if you pressed ‘BUY’ at 1.30870, your final order would be live at 1.30885 (which is 1.5 pips higher than the initial price).
In either scenario, your position would show a slight negative (which shows up in your equity) to compensate for the spread. It’s worth noting that the spread is already built into the order and doesn’t show as an actual charge in your transaction history.
A spread in forex applies to a standard account and most other account types. Another model used by brokers is where you have a lower or fixed spread along with a set commission. This is typically the case with so-called ‘zero spread’ accounts.
The purpose of such accounts is to have predictable trading costs, which is particularly useful for high-frequency traders who must pay more attention to execution charges.
Generally, when observing foreign exchange spreads, we have two types: a fixed spread and a variable or floating spread (more on them in a bit).
The extent of forex trading spreads is influenced by numerous factors like liquidity, the type of pair, and whether there are volatile events like high-impact news announcements.
Types of forex spreads
We’ll now look at the two types and which traders they suit.
Fixed FX spreads
So, what does the spread mean in forex when it’s fixed? It’s exactly as the term suggests. A fixed spread remains largely the same for much of the trading day. So, how is this possible? Fixed spreads are common with ‘market maker’ or ‘dealing desk’ brokers.
Naturally, a spread in forex is something that fluctuates with price. Yet, the challenge with FX is that it’s a decentralized market. This means that even though prices are always in a state of flux, each broker has its own pricing.
These look quite similar, but they are not technically the same, depending on where the broker derives its pricing. The first model is with straight-through processing (STP), and this system is what experts consider the most transparent.
Here, the broker passes your order to an external liquidity provider or the interbank market, which is essentially a large commercial bank like Citibank, UBS, Barclays, etc. By definition, STP means that the broker shouldn’t have any influence on the FX spread.
Since the prices come directly from the source, traders regard the model as the truest form of pricing.
However, the alternate system, the dealing desk or market maker, is where the broker processes your orders internally. Because they have more control over the prices, they can effectively set their own exchange rates and employ a fixed spread in forex.
The fear here is potential manipulation. Yet, the dealing desk model is much more common than most traders believe. There is nothing to worry about, provided the broker is regulated and provides consistent execution.
So, what are the benefits of a fixed spread in forex trading? Fixed spreads are not necessarily cheaper (since they come with a commission). However, they are more calculable, unlike variable spreads.
This is an advantage if you’re a scalper, trade with robots/automated systems, trade news events, or exotic pairs. When you know in advance how much you will forfeit in FX spread, you can calculate how much they take from potential profits.
Variable FX spreads
A variable forex trader spread is the opposite of a fixed spread. It changes and varies due to different factors like time of day and volatility. As we’ve already mentioned, variable spreads come directly from the interbank market, which is the source of foreign exchange.
Despite the perceived transparency, we should remember that it is impossible to determine the execution model a broker uses. Most brokers are quite mum about how they derive the spread on forex trading.
In simpler terms, never believe a broker that suggests STP without proof. Otherwise, variable spreads can be tighter than fixed spreads and, therefore, cheaper. On the downside, the fact that they vary, of course, means that they can be too wide.
In this way, it is harder to have predictable costs, particularly for an investor that trades frequently.
Yet, a variable spread in forex isn’t much of an issue if you know which times to avoid as a trader.
Generally, long-term traders like swing traders and position traders don’t have to worry about whether their spread is fixed or variable.
The table below summarises the pros and cons of FX spreads.
|Type of spread||Pros||Cons|
|Fixed||– Well-suited for short-term, expert advisor and news traders|
– Remains relatively unchanged for most of the trading day
– Spread fluctuations are less common-
|– Less transparent|
– Prone to manipulation (if the broker is unregulated)
– Tighter or cheaper spreads aren’t possible
|Variable||– Best suited for medium and long-term traders|
– Tighter or cheaper spreads are possible
|– Not totally transparent|
– Less predictable spreads
– Wider spread fluctuations are more prone
How is the spread in forex calculated?
Remember that the spread is a small charge already factored into every position automatically. Still, we will guide you in the process if you are interested in how much it is worth.
The main elements to know when calculating the currency spread are:
- The pip value
- The lot or unit size
- Conversion price
The pip value and lot size are intertwined because you need the latter to derive the former. Let us assume you were trading a standard or one lot on GBP/USD (as per the image below).
Here, the forex spread is 1.6 pips. We need to know a standard lot is worth 100 000 units. The formula to calculate the pip value for this pair is:
0.0001 X unit size X conversion price
The conversion price for GBP/USD (if your account is USD-denominated) is 1. So, the spread here is:
$10 = 0.0001 X 100 000 X 1
Let us go through another example.
For this image above, let us assume the trader’s account was EUR-based. Here, the unit size is 25 000 units (0.25). So, what is the forex spread here? The answer is 2.6 pips.
The conversion price is generally based on the exchange rate of your base account currency which, in this case, is EUR. So, we would derive it directly from EUR/CAD. If we wanted to go long (buy), the conversion price would be 1.38204.
So, the final FX spread is:
€3.45 = 0.0001 X 25 000 X 1.38204
What influences the changes in FX spreads
In an ideal world, the spread in forex shouldn’t vary. Yet, there are specific but rare situations where it can change noticeably. So, let’s look at those factors in more detail.
The largest contributor to a change of spread in forex is news announcements, particularly those of a known high impact like interest rate decisions and employment figures. During these periods, there is great uncertainty in the markets.
Typically, traders anticipate the likely result of a news event, especially those looking to make a quick profit. Everyone is eager to know whether the forecast will become true.
With skepticism comes the potential for prices to fluctuate erratically. In short, things can get pretty haywire, resulting in a drastic change in the spread.
Due to the higher speculative interest, there are many more orders for brokers to process during this period. It becomes challenging for them to derive a consistent exchange rate for that duration, making it risky to continue processing. So, they will need to increase the trading costs to compensate for the effort.
Here, using a fixed spread account is useful because the currency spreads will be lower than on a variable spread account.
Even if you are not an active participant during news events, you should keep an eye on an economic calendar. A trading opportunity may present itself before these intervals. Therefore, you might need to avoid it entirely or wait a bit longer to stay away from a potential forex spread spike.
Time of day
While things generally run smoothly most of the time, knowing which periods are likely to result in higher FX spreads is essential. The first stretch to note is the session overlaps, which are the London-New York and Sydney-Tokyo sessions.
The image above represents the GMT intervals for the four main FX sessions. A session merely represents the opening and closing times of the financial centres for the respective regions. An overlap means that two of these are running at the same time.
So, how does this affect the spread in forex? Simple. It boils down to an influx of traders. More people are getting involved in the markets if one session overlaps with another.
Similar to how the higher interest in news-driven events creates potential volatility, so do session overlaps. Again, there is more risk for the broker to process more orders and maintain consistent pricing.
So, they have to widen the spread to continue their operations profitably. However, this is only in the first hours, after which points things stabilize.
Another notable time forex trading spreads widen is during the rollover, which means several things. Firstly, this time signals the start of a new trading day, which is generally 21h00 GMT, the beginning of Sydney’s session.
This interval is simultaneously the end of the New York session. So, the positions from this point ‘roll over’ into the Sydney session. What happens here is that dealers temporarily reset their systems to be aligned with the new prices at the start of the new trading day.
Also, fewer people are trading during this time, which usually lasts no more than 60 minutes. Many people consider it an after-hours period, but it’s simply a rollover. So, brokers generally widen forex spreads briefly before everything returns to normal.
What is a good spread in forex?
Needless to say, it depends on the type of pair. For major pairs, you shouldn’t pay above a two-pip spread generally. EUR/USD is always the cheapest, where you can incur a spread lower than a pip.
The most to expect with cross pairs is 5-6 pips, but this will depend on the broker and whether the spread is fixed or spread. Generally, major and cross pairs have reasonable trading costs, whether you are a short or long-term trader. The level of competition from other brokers and the massive demand equals a low spread in forex.
Yet, exotics are a different beast altogether, where you can incur FX spreads in the tens of pips, depending on the pair and broker. It is harder to gain an average because many more of these pairs exist compared to other forex pairs.
Exotics are thinly traded and are, therefore, less liquid. Since fewer people are participating in these pairs, the broker has to increase the transaction costs to offset the risk of lower demand.
Having a fixed spread account here is beneficial since you generally have a lower spread that is less prone to fluctuate.
So, there you have it: our forex spread explained guide. One massive benefit of currency trading is that the trading costs are minimal. Yet, there are some nuances regarding spreads that can affect the bottom line of certain traders.
There are several methods of lowering the spread in forex, such as trading less frequently, considering a fixed spread account, avoiding exotic pairs, and staying away from specific market intervals.