Introduction
If you are a forex trader or thinking about becoming one, you must have an understanding of spreads. The spread is the small difference in the price when you buy or sell currency pairs. Although the spread may look small, the effect in forex trading is much more significant when it comes to your trading profits.
In this blog, we are going to cover the impact of spreads in forex trading, how to calculate them, and how to reduce your trading costs. This is particularly useful if you are new to forex trading, and want to maximize your profits.
What Is a Forex Spread?
In forex trading, there are two prices for every currency pair. These prices are as follows:
- Bid Price- The price at which you can sell to the broker.
- Ask Price- The price at which you can buy from the broker.
The difference between the ask and bid price is the spread.
Example:
If EUR/USD has an ask price of 1.1010 and a bid price of 1.1005, then the spread is 0.0000. or 5 pips.
Why Do Spreads Exist?
Brokers make money from spreads. Instead of charging you directly, they earn a small amount from each trade through this price difference. So, the spread is a hidden cost you pay each time you open a trade.
The Real Impact of Spreads in Forex Trading
Suppose you take a position in a market and it doesn’t move in a significant direction. You still show a small loss immediately when you open your position due to the spread. You are always buying high and selling low relative to the bid and ask prices you are looking at in the market.
So,
- Wider spreads = higher costs
- Narrower spreads = lower costs
By recognizing and understanding spreads, you’ll have an essential component to consider in your trading cost analysis.
Spread Effect on Strategy
Your trading style can change how spreads affect you.
1. Scalping
If you are a scalper (i.e. you make lots of small trades), spreads are very important to you. A large spread can eat into your profits quickly.
2. Day Trading
Day traders feel the impact, too. They open and close trades frequently, therefore the spreads can add up overtime.
3. Swing or Position Trading
Longer-term traders are not so concerned with spreads provided they are holding trades for days and/or weeks. The spread is small when compared to their profit targets.
Types of Forex Spreads
1. Fixed Spreads
- Always stay the same
- Good for beginners
- Easy to calculate costs
2. Variable (Floating) Spreads
- Change with market conditions
- Can be very low during calm times
- Can grow wide during news or high volatility
How to Calculate Forex Spread Cost
Let’s do a simple forex spread calculation.
You trade 1 lot of EUR/USD (100,000 units).
Spread = 2 pips
Pip value (EUR/USD) = $10 for 1 lot
Cost = 2 x $10 = $20
So, you pay $20 to enter that trade. That’s your cost before any profit or loss.
How to Minimize Trading Fees from Spreads
Here are some smart ways to reduce costs from spreads and keep more profits.
1. Trade Major Currency Pairs
Major currency pairs like GBP/USD or USD/CHf have narrow spreads. Exotic currency pairs like USD/TRY have larger spreads.
2. Trade with Market Active
Market spreads are narrowest when trading is active (like during the London session and New York session). Avoid trading during less active times when spreads are wider.
3. Use ECN Brokers
You can get pretty tight spreads when using ECN (Electronic Communication Network) brokers. These brokers do charge you a commission but the overall cost is usually lower.
4. Get a Low Spread Broker
Research and analyze trading costs prior to making your first deposit and opening an account some brokers can have a zero spread or ultra-low spread.
5. Don’t Trade on High Impact News
On high impact news, spreads can widen too much. Unless you are an expert trader, avoid trading on high impact news events at all costs.
Spread and Leverage – A Hidden Risk
If you use leverage (borrowed money), even a small spread can have a big impact. For example:
- Spread = 3 pips
- Leverage = 1:100
- You are using a large position size
This makes the cost much bigger. That’s why you must understand both spread and leverage before you start trading.
Conclusion
The reality of spreads in forex trading has an impact on your profits as much, or possibly much more, than you think. Regardless of whether you are a novice or experienced trader, understanding how spreads work is critical.
Keep in mind:
- Your spread is a component of your cost of trading.
- Choose brokers that have the lowest spreads possible.
- Engage in trading during active trading sessions.
- Do not trade low liquidity pairs, stick to major pairs that have little to no spread.
- Use a demo trading account to practice when spreads widen and what the cost of spread is on average to be able to trade much more economically when you do go live.
By properly managing your spreads, you will be able to hold all your profits or at least a lot more of them and trade smarter.
FAQs
Q1. What is a good spread in forex trading?
A: A good for major pairs is 1 – 2 pips. Lower spreads are better; they reduce your overall trading cost.
Q2. Why do spreads widen?
A: Spreads widen during news events and during times when there are fewer trades happening (low volume).
Q3. Are fixed spreads better than floating spreads?
A: Fixed spreads provide more predictability. Floating spreads have the potential to being a smaller spread than a fixed spread but can change frequently. A beginner may want a fixed spread.
Q4. Do spreads affect my strategy?
A: Yes. If your strategy is making many small trades (like scalping) your spread will impact you significantly.
Q5. How can I track the cost of my spread?
A: You can check your trading platform for order history or calculator tools. Some brokers also show your trading cost clearly.
