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What is Spread ?
Spread in the Forex Market
The forex spread is the difference between the exchange rate that a forex broker sells a currency and the rate at which the broker buys the currency.
✓ The forex spread is the difference between a broker’ sell rate and a buy rate.
✓ The forex spread could be narrow or widen. That depends on the currency, at which time of day the trade is initiated, on the volatility and economic conditions.
Understanding Forex Trading
Forex trading is the actions that a trader takes to buy and sell currencies at their exchange rates.
The difference between the buy rate and the sell rate is the trader’s gain or loss on the transaction. It’s important to understand how currencies are quoted by forex brokers like FxPro.
How Currencies Are Quoted
Currencies are always quoted in pairs, such as the U.S. dollar versus the Canadian dollar (USD/CAD). The first currency is called the base currency, and the second currency is called the counter or quote currency (base/quote).
For example, if it took $1.2500 (Canadian dollars) to buy $1 (U.S. dollar), the expression USD/CAD would equal 1.2500/1 or 1.2500. The USD would be the base currency, and the CAD would be the quote or counter currency. In other words, the rate is expressed in Canadian terms, meaning it costs 1.25 Canadian dollars to buy one U.S. dollar.
However, some currencies are expressed in U.S. dollar terms, meaning the USD is the quote currency. For example, the British pound to U.S. dollar exchange rate of 1.2800 would be quoted as $1.2800 (dollars) for every British pound. The pound is the base currency and would be abbreviated as GBP/USD.
The euro is also quoted as the base currency so that one euro at an exchange rate of 1.1450 would mean it costs $1.1450 (in dollars) to buy one euro. In other words, the EUR/USD would be quoted by a broker as $1.1450 to initiate a trade.
How the Spread is Calculated in the Forex Market
Now that we know how currencies are quoted in the marketplace let’s look at how we can calculate their spread. Forex quotes are always provided with bid and ask prices, similar to what you see in the equity markets.
The bid represents the price at which the forex market maker or broker is willing to buy the base currency. Conversely, the ask price is the price at which the forex broker is willing to sell the base currency in exchange for the counter currency.
The bid-ask spread is the difference between the price a broker buys and sells a currency. So, if a customer initiates a sell trade with the broker, the bid price would be quoted. If the customer wants to initiate a buy trade, the ask price would be quoted.
For example, let’s say a U.S. investor wants to go long or buy euros, and the bid-ask price on the broker’s trading website is $1.1200/1.1250. To initiate a buy trade, the investor would get charged the ask price of $1.1250. If the investor immediately sold back the euros to the broker, the investor would get the bid price of $1.1200 per euro (assuming the exchange rate hadn’t fluctuated). In other words, the speculative trade cost the investor $.0050 solely due to the exchange rate’s bid-ask spread with the broker.
How Forex Spreads Are Quoted
Spreads can be narrower or wider, depending on the currency involved. The 5 pip spread between the bid and ask price for EUR/USD is fairly typical. The spread might normally be one to five pips between the two prices. However, the spread can vary and change at a moment’s notice given market conditions.
Each broker can widen their spread, which increases their profit per trade. A wider bid-ask spread means that a customer would pay more when buying and receive less when selling. In other words, each forex broker can charge a slightly different spread, which can add to the costs of forex transactions.
Time of Day
The time of the day that a trade is initiated is critical. An example, European trading opens in the wee hours of the morning for U.S. traders while Asia opens late at night for U.S. and European investors. If a euro trade is booked during the Asia trading session, the forex spread will likely be much wider than if the trade had been booked during the European session.
In other words, if it’s not the usual trading session for that particular currency, there won’t be many traders involved, causing a lack of liquidity. If the market isn’t liquid, it means that the currency isn’t easily bought and sold. As a result, forex brokers widen their spreads to account for the risk of a loss if they can’t get out of their position.
Events and Volatility
Economic and geopolitical events are drivers for widening the forex spreads. An example, if the unemployment rate for the U.S. comes out much higher than anticipated, the dollar against most currencies would likely weaken or lose value. Periods of event-driven volatility can be challenging for a forex broker to pin down the actual exchange rate, which leads them to charge a wider spread to account for the added risk.