What are Forex Spreads? Why Spreads Matter in Forex Trading?

What's more, brokers can manipulate spreads on their trading platforms, so it's very essential to understand spreads in the FX market.

In this article, we will provide you with a detailed explanation of the spreads, the various types of the spreads and why the spreads matter in forex trading with some examples.

What is Forex Spread？

In the forex market, a spread is simply defined as the price difference between the BID price and the ASK price quote (buy/sell) in a currency pair.

There are always two prices given in a currency pair, the bid and the ask price. The bid price is the price at which you can sell the base currency, whereas the ask price is the price you would use to buy the base currency, and in forex trading, the spread is the difference between the bid (sell) price and the ask (buy) price of a currency pair.

The base currency is shown on the left of the currency pair, and the variable, quote or counter currency, on the right. The pairing tells you how much of the variable currency equals one unit of the base currency.

Let me give you an example, If at any point the quote for the euro against the US dollar is 1.1400 – 1.1402 it reads as follows:

EUR/USD=1.1400/1.1402

Since we know the difference between BID and ASK is best known as the spread, and the spread is expressed as pips or points, so in this example, the spread in the EUR/USD is 2 pips or points.

Common Spread Types in Forex - Fixed Spreads VS. Floating Spreads

The type of spreads that traders will see on a trading platform depends on the forex broker and how they make money. Usually, there are two types of spreads: Fixed Spreads and Floating Spreads.

1. Fixed Spreads in Forex

Fixed spreads is the difference between Ask and Bid prices that remains the same even though the prices are changing. As opposed to floating spreads, fixed spreads do not fluctuate at any given time because of market conditions. Fixed spreads allow trading with confidence, as traders know the trading costs at any time, regardless of the period of the day, regardless of levels of liquidity or volatility.

2. Floating Spreads in Forex

Floating Spreads is the difference between Ask and Bid prices that may vary depending on the market situation. It accurately reflects the prices of trading instruments and how quickly they are changing. Floating spread may have range that is lower than typical when the market is quiet and liquidity is high.

3. Pros and Cons of Fixed Spreads and Floating Spreads

>Fixed Spread

*Could face requotes

*Smaller capital requirements

*Predictable transaction costs

*More appropriate for novice traders

*A volatile market won't effect the spread

*Likely to be exposed to slippage

> Floating Spreads

*No risk of requotes

*Can reveal market liquidity

*Can get a tighter spread than fixed

*More appropriate for experienced traders

*Spread can widen rapidly if there is high volatility

*Can be exposed to slippage

Why do the Spreads Change in Forex？

Fixed spreads change very rarely, but floating ones are guaranteed to do so. The most common case when a spread change is when there's a shift in the market.

There are some few factors can widen or narrow a forex spread.

1. Time of Day

The time of the day that a trade is initiated is critical. European trading, for example, 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 normal trading session for the currency, there won't be many traders involved in that currency, causing a lack of liquidity. If the market isn't liquid, it means that the currency isn't easily bought and sold since there aren't enough market participants. 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.

2. Events&Volatility

Economic and geopolitical events can drive forex spreads wider as well. If the unemployment rate for the U.S. comes out much higher than anticipated, for example, the dollar against most currencies would likely weaken or lose value. The forex market can move abruptly and be quite volatile during periods when events are occurring. As a result, forex spreads can be extremely wide during events since exchange rates can fluctuate so wildly. 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 of loss.

3. Brokers

All investors and traders should be educated about the lack of information regarding the possibility of manipulating the spreads on their trading platforms without the consent of their clients. On certain occasions there are unscrupulous brokers which exercise this practice to obtain more profits. Therefore it's essential that the trader selects a quality broker with a good reputation and that is not guilty of any spread manipulation.

Why the Spreads Matter in Forex？

It's very important to know the spread in the forex market. The spread is the cost of each transaction that the broker charges and determines if that cost is appropriate for your trading style. The spread is a cost factor for the trader and the more you trade the more you are hit with the cost.

1. Spread&Commission

The spread in forex is considered one of the best options for both brokers and traders, but it doesn't mean that there is no alternative method for it. That alternative method is the commission. It's usually very different depending on the broker you are trading with, but it doesn't mean spreads and commissions can't be compared.

The main factor is probably the guarantee of spreads and the unpredictability of commissions. You see, when the spread is fixed, you as a trader are already aware of how much you will pay for the broker's services. But when you are on commissions, they could change dramatically. For example, your trade can grow overnight making you pay a commission, it could reach a deadline making you pay a commission or you could accidentally close the trade too early and again pay a commission.

The logic is quite clear, spreads may be slightly more expensive when we first look at them, but in the long run, commissions are much more likely of costing you more.

2. Spread&Margin

If the forex spread widens dramatically, you run the risk of receiving a margin call, and worst case, being liquidated. A margin call notification occurs when your account value drops below 100% of your margin level, signaling you're at risk of no longer covering the trading requirement. If you reach 50% below the margin level, all your positions may be liquidated.

It's therefore important to gauge how much leverage you're trading with and the size of your position. Forex pairs are usually traded in larger amounts than shares, so it's important to remain aware of your account balance.