Spreads: What Does it Mean & How it Affects Forex Trading

In forex trading, you’ll often hear about something called the “spread.” But what does spread mean in forex? It’s pretty simple: spread is just the gap between the price someone wants to sell a currency for (the bid price) and the price someone else wants to buy it for (the asking price). So, when you make a trade in forex, the spread is like a little fee you pay for that trade.

What is spread in forex trading?

In forex trading, the spread is a key factor that determines how much it costs to make a trade. It’s the gap between the price someone wants to sell a currency for and the price someone else wants to buy it for. When traders buy or sell currencies, they see two prices: the bid price (for selling) and the ask price (for buying). The spread is what the broker earns for helping with the trade.

Types of spreads in Forex:

There are different types of spreads that traders come across in forex trading:

• Fixed Spread: This type of spread stays the same no matter what the market conditions are like. Brokers who use a market maker or dealing desk model usually offer fixed spreads. With fixed spreads, traders always know how much each trade will cost, which makes things predictable. But remember, fixed spreads might widen when the market gets more volatile.
• Variable Spread: Unlike fixed spreads, variable spreads change depending on how the market is doing. Brokers who don’t use a dealing desk often offer variable spreads. These spreads can get wider or narrower depending on factors like market volatility and liquidity. While variable spreads can be good when the market is calm, they might cost more during busy times.

Understanding the importance of spread in forex trading

The spread is a crucial aspect of forex trading, as it directly affects how much it costs to make trades, which ultimately impacts traders’ profits. Essentially, it’s the difference between the buying and selling prices quoted for a currency pair.

Example

A narrower spread means the prices for buying and selling are closer together, resulting in lower costs for traders. For example, if the buying price for the EUR/USD pair is 1.2000 and the selling price is 1.2005, the spread is 0.0005, or 5 pips. With a narrow spread, traders can make trades more efficiently and keep more of their potential profits.

Conversely, a wider spread means there’s a bigger gap between buying and selling prices, leading to higher costs for traders. If the same EUR/USD pair now has a buying price of 1.1995 and a selling price of 1.2010, the spread is 0.0015, or 15 pips. In this case, traders would spend more on making trades, which could reduce their overall profits.

Understanding how spread works is vital for creating successful trading strategies and improving trading performance. For instance, traders who make many quick trades (scalpers) often prefer brokers with tight, fixed spreads. These spreads stay the same, making it easier for scalpers to predict their costs and maximize their profits.

On the other hand, traders who hold positions for longer periods (like swing or position traders) might choose brokers with competitive variable spreads. Variable spreads change based on market conditions, getting tighter when the market is busy and wider when it’s volatile. By adjusting to market changes, traders can take advantage of favorable spread conditions and improve their trading results.

Knowing the importance of spread in forex trading is key for traders looking to succeed in the market. By understanding spread dynamics, choosing the right spread type for their strategy, and keeping an eye on market conditions, traders can reduce costs, increase profits, and achieve long-term success in the forex market.

Who determines the spread?

The spread in forex trading depends on several important factors, each playing a vital role in how it’s decided. Market liquidity is a big one—it’s about how easy it is to buy or sell assets without affecting their prices much. In markets with lots of trading activity, like major currency pairs during busy trading times, spreads are usually smaller because there are plenty of buyers and sellers.

Volatility is another factor. When the market gets more volatile, spreads tend to get wider. This happens because brokers adjust their prices to deal with bigger price swings and possible gaps in the market. But when volatility goes down, spreads can shrink because things are more stable.

Brokers also have a say in spreads. Depending on how they set their prices, they might offer fixed or variable spreads to traders. Market maker brokers, who trade against their clients, often give fixed spreads that stay the same no matter what’s happening in the market. But brokers using an agency model or a non-dealing desk usually offer variable spreads that change in real-time based on how busy the market is and how much it’s moving.

Liquidity providers, like banks and financial institutions, also affect spreads. They give bids and ask prices to brokers, who then pass them on to traders. These providers compete to offer the best prices, which affects the spreads traders see on their trading platforms.

Consequences of ignoring the spread

Not paying attention to the spread in forex trading can have serious consequences for traders. Let’s take a closer look at what could happen: 

• Ignoring the Real Cost: If traders ignore the spread, they’re missing out on a big part of the total cost of a trade. Imagine someone only looks at how much a currency pair moves without considering the spread. They might think they’ve made money when really they’ve just covered the cost of making the trade.
  • For example, say a trader buys the EUR/USD pair with a 10-pip spread. Even if the trade goes up by 10 pips, they won’t make any profit because they’ve got to cover the spread first.

• Facing Slippage: When the market gets crazy, like during big news events, prices can move really fast. That can cause slippage, where the trade gets filled at a different price than expected. Ignoring the spread makes slippage even worse because traders might not realize how much extra they’re paying when their orders don’t get filled at the price they wanted.
  • For instance, let’s say a trader wants to buy EUR/USD right when a news report comes out. Because of the spread getting wider and prices jumping around, they end up buying at a higher price than they planned. That means they’re paying more than they expected, eating into their profits.

• Dealing with Requotes: Requotes happen when the broker can’t give the price the trader asked for, so they offer a different one instead. If traders don’t pay attention to the spread, they might get caught off guard by requotes, especially when the market’s moving fast and there’s not a lot of trading happening. Requotes can mess up trading plans, delay orders, and even cause traders to miss out on good chances to make money.
  • For example, a trader tries to close a trade during a sudden price jump. But because the spread is wider than usual and the market’s all over the place, the broker doesn’t give them the price they wanted. This delay means they might end up losing more money or missing out on a chance to cash in on their profits.

Seeking lower spreads in forex trading

To get the most out of forex trading and minimize the effect of spreads, traders can follow these simple strategies:

• Pick a Good Broker: Look for brokers with a good reputation for offering fair prices and clear trading terms. Make sure they’re regulated by trustworthy authorities and compare their spreads to find the best deal.
• Trade When It’s Busy: Liquidity, or how easy it is to buy or sell without messing up prices, matters. Trading when lots of people are buying and selling, like when big trading sessions overlap (think London and New York), can mean lower spreads. More trading activity usually means better deals for traders.
• Use Limit Orders: Instead of just jumping in at whatever price the market offers, try using limit orders. These let you set the exact price you want to buy or sell at. By factoring in the spread when setting these orders, you can make sure you get in or out at the price you want, even when spreads widen during crazy market times.

Know how spreads affect forex trading

To do well in forex trading, it’s important to get how spreads work. When you understand spreads and how they affect your trading costs, you can make smarter choices and improve your strategies. Whether you’re dealing with fixed or variable spreads, knowing about spreads helps you navigate the forex market better.