Forex trading may be a confusing endeavor at the start, with many terminologies that traders come across, including pips, lots, and spreads. However, one of the key elements that traders need to know before entering the market is spread. Without understanding spreads, it would be challenging to control profit and loss.
This basic guide will teach you about what is spread in trading, how spreads operate in forex trading, the various types of spreads, and how spreads influence a funded trading account.
Spread in Trading Defined
The most basic definition of spread in trading is that:
Spread refers to the gap between the buying price (ask price) and selling price (bid price) of any currency pair.
When trading forex, brokers provide two prices:
- Bid Price – Selling price
- Ask Price – Buying price
The slight gap between the bid and ask price is known as the spread.
For instance:
- Bid Price EUR/USD = 1.1050
- Ask Price EUR/USD = 1.1052
Thus, the spread here is 2 pips.
The spread is essentially the commission charged by brokers for providing access to the market.
The Importance of Spread in Currency Trading
Spreads should be considered vital in understanding currency trading, since spreads have a direct effect on gains and losses.
Every time you place an order, you will be faced with an initial loss equivalent to the spread. Your position has to go in your favor first before you earn any gains.
For instance:
- When you buy the EUR/USD with a 2-pip spread, the market has to move up by 2 pips before you reach breakeven.
- Day traders and scalpers are particularly concerned about spreads because they trade a lot throughout the day.
Spread in Forex Trading
To fully understand what is spread in trading, one needs to know about the forex prices movement.
These prices are always moving due to supply and demand. The brokers introduce a spread that is added to the price to make money.
Example of Spread in Forex
Let's consider the example when you make a trade on GBP/USD:
- Price for Buying = 1.2505
- Price for Selling = 1.2503
So, the spread will be:
1.2505 – 1.2503 = 0.0002
Or in forex – 2 pips.
In case the market moves up from 1.2505 to 1.2515, you get 10 pips profit after excluding 2 pips spread.
Types of Forex Spreads
There are two major types of spreads in forex trading.
Fixed Spread
A fixed spread does not change under any market circumstances.
Examples include:
EUR/USD spread that stays constant at 2 pips throughout the day
Advantages of Fixed Spreads
Paying predictable transaction fees
Suitable for newcomers
Easy management of risks
Disadvantages
Tend to be wider compared to variable spreads
Requotes during periods of high volatility from brokers
Variable Spread
Variable spreads fluctuate based on market conditions.
Spreads increase greatly in case of major economic news events.
Advantages of Variable Spreads
Narrow spreads when the market is stable
Suitable for skilled traders
Disadvantages
Very wide in case of increased volatility
Predicting transaction fees becomes difficult
What Makes Fore Spread Vary?
Forex spreads vary due to various reasons.
Market Volatility
Market volatility makes the spread widen since the prices become unpredictable.
This is seen during periods such as:
- Interest rates releases
- Inflation figures
- Economic data release
- Liquidity
Pairs with high liquidity will usually have small spreads.
Some examples of such pairs are:
- EUR/USD
- GBP/USD
- USD/JPY
Exotic currencies are paired with large spreads owing to less people trading them.
Trading Sessions
The spread is smaller during trading sessions including:
- London session
- New York session
What Are Spread and Pips?
Pip refers to the minimum amount by which an exchange rate moves.
Most currencies move up to four digits.
For example:
- 1 text{pip} = 0.0001
- In this case, if EUR/USD changes from 1.1000 to 1.1005, the change would be 5 pips.
- The spread is usually calculated in pips.
How Spread Impacts Your Trading Strategy
Your trading approach influences how you manage the spread.
Scalping
A scalper profits from making many small trades. The spread becomes critical since a large spread would mean losses.
Day Trading
A day trader profits from the changing prices on the stock market, but he/she does not hold the position overnight.
Hence, the smaller the spread, the better.
Swing Trading
Selecting a Broker with Low Spreads
The best broker must offer:
- Low spreads
- Quick execution
- Reliable trading platform
- Clear fees
Newcomers should stay away from brokers with hidden fees and excessive spreads.
It is always necessary to compare spreads before signing up with any broker.
Spread for a Funded Account
Spread plays a vital role in trading a funded account.
A funded account is offered by a prop firm where traders receive funding from the company following completion of an evaluation test.
Generally, there are tough terms and conditions set by most prop firms, including:
- Maximum losses per day
- Total drawdown
- Targets
High spreads can make it difficult to meet these requirements.
Significance of Spread for a Funded Account
Let’s assume that you are trading with a funded account and making several transactions per day.
In case of high spreads on all trades:
- Costs increase
- Payouts become low
- Drawdown happens quickly
This makes traders lose the funded test despite having an excellent trading strategy.
This is the reason why most prop firm traders choose:
- Popular currency pairs
- Brokers with low spreads
- High liquidity sessions
Suggestions for Reducing Spread Costs
There are several suggestions that can be implemented to reduce your costs regarding spreads.
Use Major Currency Pairs
Spread costs are normally lower with major currency pairs since these pairs are highly liquid.
Some examples are:
- EUR/USD
- GBP/USD
- USD/JPY
Do Not Trade on Economic Events
During economic events or announcements, spreads tend to go extremely high.
It is advisable to trade after some time once volatility subsides.
Trade During Sessions
The most favorable times to trade are when London and New York sessions overlap.
Limit Orders
A few brokers provide limit order prices.
Common Mistakes Made by Beginners About Spreads
Neglecting Spread Costs
Most beginners concentrate solely on strategy without realizing that spreads lower profitability.
Trading Exotic Currency Pairs
Exotic currency pairs typically have massive spreads that beginners find hard to manage.
Overtrading
Opening many trade positions increases spread expenses immensely.
Trading Under Low Liquidity
Low liquidity markets frequently have high spreads.
Concluding Remarks
Understanding what the spread is all about constitutes one of the essential aspects of becoming a successful forex trader. Spreads, which represent the difference between the purchase and sale prices of currencies, play a crucial role in trading.
A spread that is lower allows traders to make savings, trade efficiently, and handle risks effectively. It is all the more relevant in funded accounts where each pip is critical for the reason that prop firms have strict policies.
Some things that beginners need to know include:
- How to calculate spreads
- Currency pairs with low spreads
- Active trading periods
- Handling fees effectively