Understanding spreads in forex trading

In every kind of financial trading, the spread on any given transaction plays a large part in determining the level of profit achieved. In short, the spread is the difference between the buying and selling price of a given asset and can vary from one broker to another. The situation is more complex with foreign exchange (forex) trading because when buying and selling currency there is no clear distinction between asset and price.

Relative value

In forex trading, different currencies only have value relative to each other, and forex traders always think in terms of currency pairs. In some ways, it’s the same as going to a bureau de change. You may think that you are buying 50 euros for 42 pounds, but really you are exchanging one currency for another at the current exchange rate.

However, if you change your mind and decide to return your 50 euros and get your 42 pounds back, you may find that the rate of exchange is slightly different. Fifty euros may only get you 41 pounds. This difference, between the buying and selling price of one currency, expressed in another currency, is the spread. This will also vary from one broker to another and is the primary way that brokers profit from your trades.

What are the best spreads?

When choosing a broker, it makes sense to look for the one with the tightest spreads. This means that the difference between the buying and selling price in the currency pairs you’re interested in is smaller than the difference at other brokers. Tight spreads are not the only factor you should consider when choosing a broker. It’s particularly important to seek out safe crypto brokers, for instance. But the less you pay in terms of the spread, the greater your potential profits.

While other markets may offer fixed spreads that don’t change, in forex, you’ll always find variable spreads which can fluctuate due to a number of causes. This is because the broker has to consider the constantly shifting exchange rate. This, in turn, is influenced by a wide range of economic, political and day-to-day factors, from major news announcements to extreme weather events.

Calculating spreads

The size of the spread is measured in terms of tiny price movements called pips. These usually take place at the fourth decimal place of a currency pair. The exception is when the trading price is quoted in Japanese Yen (JPY), when it’s calculated at the second decimal place.

The spread per unit of currency is often a minimal amount, but it adds up when you are trading large lots of said currency. A large or high spread is called a wide spread, while a small or low spread is a tight spread.

What causes spreads to change?

The more pips, the wider the spread, and spreads can get wider or tighter in response to events or even at different times of day. For instance, if the market for one side of your chosen currency pair isn’t currently open, due to global time differences, then the spread will generally be wider. This is because fewer people than usual are trading in that currency, as the market isn’t open, leading to low liquidity.

Low liquidity and a volatile market contribute towards making spreads wider. If the market is stable and liquid, then spreads will generally be tighter. Major currency pairs will usually have tighter spreads because more people are trading in them, and they are considered to be stable. The currencies of emerging nations may have wider spreads.

How spreads affect your trade

If a spread widens significantly and quickly, your positions might be closed. You could also be put on a margin call. Even if the shift is not quite as dramatic, your profits could turn out to be less than you expected if the spread has changed.

Some events that will affect spreads can be predicted, for instance, by keeping a close eye on world news and the political or economic climate in the home country of the currency you’re trading. Financial newsletters can keep you abreast of upcoming announcements that are likely to affect spread size.

Understanding how spreads are calculated and what factors affect them will help you to trade more profitably. Comparing brokers based on spread size is one tactic that can help you maintain a good profit margin. Timing your trades to get the best spreads will also help you to get the best value from your transactions.