The currency marketplace is now the largest in the world. Transactions to the tune of $3 trillion take place daily. Anyone can test their financial foresight by becoming a retail trader. Brokers giving access to currency exchange spreads as their competitive advantage. But what exactly does this term mean?
What Is a Spread in Forex Trading?
Most of the time, the spread is measured in “pips,” which is the smallest change in price of a currency pair.
One pip is equal to 0.0001 for most currency pairs.
For EUR/USD, a 2 pip spread would look like 1.1011/1.1013.
Remember that in every forex trade, you buy one pair of currencies and sell another.
The currency on the left is called the base currency, and the currency on the right is called the quote currency. When trading foreign exchange, the bid price is how much the base currency costs to buy, and the ask price is how much it costs to sell.
When you trade forex with us, you will use leverage. This lets you trade large amounts of currency without having to pay the full value of their trade up front. You can go long or short, which means you can bet on the price of a currency going up or down. And to open your position, you only need a small deposit, called “margin.”
Definition of the Term
Every base currency may be bought or sold based on the corresponding prices. The “Bid” value shows the price for the seller (e.g. EUR/USD 1.26 means 1 Euro is sold for 1 US dollar 26 cents), while the “Ask” price displays that for the buyer (e.g. EUR/USD 1.28 means 1 Euro is bought for 1 US dollar 28 cents). Based on the general logic of sales, any currency is slightly more expensive for its buyer than for its seller.
Measurement of Spreads
The units of measurement are known as pips. Each is equal to 0.0001 for almost any pair, and it is the smallest possible fraction. Consider the following example for the EUR/USD combo.
The Ask price is 1.1011, and the Bid price is 1.1013. The spread is calculated as the difference between the latter and the former. Therefore, the example shows a 2-pip spread.
The only exception is combinations with the Japanese yen. These are quoted to only two decimal places (three in case of fractional pips). Consider this example with the Yen as the counter currency. If USD/JPY costs 122.00/122.04, the spread constitutes 4 pips.
Types of Spreads
The exact classification varies between brokers. Check your provider’s website for detailed information. Generally, there are three key categories:
1. Fixed Spreads
These are provided by companies that fulfill the “market maker” or “dealing desk” broker services. The rates remain unchanged regardless of any market shifts. Even in a situation of wild turbulence, the spread will not be affected.
The dealing desk model means the company purchases large volumes from the liquidity provider. The goal is to split the positions into smaller shares and sell to traders. This makes fixed spreads possible as the broker can control the prices.
2. Variable Spreads
As the term suggests, these are constantly in flux, along with the difference between the bid and ask values.
These are offered by another type of brokers that rely on pricing from several liquidity providers.
No dealing desk is involved. Essentially, they do not control the spreads at all. The value is only determined by the supply and demand for currencies and volatility on the marketplace overall.
Not only does the spread determine the profit you make from an exchange, but it also constitutes the profit of your provider if the company positions itself as a zero-commission broker.
These companies do not charge a separate fee for every transaction. Instead, they build this into the rates. Hence, there is no such thing as “no commission”. Otherwise, brokers would have no benefit.
How to calculate the spread
In forex, you need to figure out the difference between the buy price and the sell price in pips to figure out the spread. You do this by taking the difference between the ask price and the bid price.
For example, if you trade GBP/USD at 1.1019/1.3091, the spread is 1.1021 – 1.1019, which is 0.0002. (2 pips).
The main cost of a currency trade is the forex spread, which is built into the price to buy and sell an Forex pair.
Spreads are measured in “pips,” which is a change in the fourth decimal place of the quote price of a forex pair (or second place if quoted in JPY)
To figure out the forex spread, take the difference between the buy price and the sell price.
Forex spreads are always different and can be either wide (high) or tight (low)
Tighter spreads are often preferred by traders because it makes the trade more affordable.
Wide spreads can happen when a market is very volatile and doesn’t move much.
Tighter spreads may happen if a market is very liquid but not very volatile.
Spreads can change because of things like important news or an event that makes the market more volatile.
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Kathleen Brooks is UK and EMEA research director and based in London. She uses both fundamental and technical methods in her analysis. Her philosophy of market analysis is to break things down to their most simple parts and build from there.
Kathleen has regularly contributed to Yahoo Finance, Reuters and often quoted in international publications such as Financial Times and the Wall Street Journal.