What are Forex Spreads?
The simple definition of "Forex spreads" is the difference in of the price at which you can go long for a currency pair or at which you can short-sell or sell the same currency pair at that very moment.
As we have seen in the explanation given under "Spreads Definition and Explanation" that in financial terms the formula of the term spread is as follows:
Spread = Bid Price - Ask Price
Bid and Ask Price
Bid price is the price which you get when you wish to sell a currency pair and ask price is the quote you get when you want to long i.e. buy the same currency pair.
Spreads in Forex Trading
Forex market is unique in one term that we buy money with money i.e. we buy one currency while paying in other currency. As money is the way we buy anything in this materialistic world and money is what we get when we sell anything in this world, buying and selling a currency pair becomes a bit different than the buying and selling of anything else. Buying a currency pair means buying the "Base Currency" or the first currency and selling the second currency (the "Quote Currency").
To make it simple let us say we are buying EUR/USD, that would mean that we are buying Euro by paying with US Dollar. That means we are buying Euro and the seller in front of us is buying USD from us. In other words we are buying Euro by selling US
Let's say that we are trading with EUR/USD. We already have a long position of EUR/USD but our analysis tells us that the uptrend is going to reverse and the currency pair may have go into a downtrend or at least some downward consolidation may come. A "Swing Trade" opportunity. So we want to close our long position i.e. sell EUR/USD to take an opposite position of short-selling EUR/USD.
Now we see two prices for both of our wished actions. To sell EUR/USD we may see a price which is slightly less than the price at which we can buy it at the same time. This difference is nothing but Forex Spreads or in this case EUR/USD Spread.
As an example we may see the bid and ask prices as follow:
- Bid Price ( at which we can sell): 1.2607
- Ask Price ( at which we can buy): 1.2609
So if we wish to buy EUR/USD from the Forex broker or dealer we have to pay 1.2609 U.S. Dollar for 1 Euro but at the same time if we want to sell EUR/USD, we would get 1.2607 U.S. Dollars for our 1 Euro.
This difference in the terms of Pips between the exchange rates of the concerned currency pairs is called the "Spread" or "Forex Spreads" for that currency pair. In the above example the difference in the ask and bid prices of 1.2609 and 1.2607 is 2 pips and hence we can say that the spread for EUR/USD is 2 pips.
Variable and Fixed Forex Spreads
A Forex broker may offer you fixed spreads or variable spreads. The fixed spread would mean that come what may, the difference in their ask and bid price will remain the same. As against that the Forex brokers with variable spreads keep adjusting their offered spreads.
Fixed and Variable Spreads - Which Forex Broker is Better?
Simply speaking there is no straight answer to this question. A market maker can always offer you fixed spreads because he can dictate the foreign exchange rates but and ECN broker or STP broker (Straight Through Processing) may not be able to do so. One thing is sure that every trader or trading entity is in the market to earn money or to have profit from any possible Forex transaction. The Forex market is a very volatile market in general. Volatility depends on currency pairs, market hours and on the events of major economic releases.
Currency Pairs and Spreads
Different currency pairs will have a different spreads. The currency majors with higher trading volumes would have less spread while the currency pairs which are not so commonly traded and the trading volumes are less tend to have higher spreads.
Example of Forex (Fx) Spreads
Let us see some examples of Forex spreads from one broker on Monday morning of Asian session.
Now if we the ask/bid prices for EUR/USD is 1.2948/1.2946. That means the spread is 2 pips for EUR/USD in this example.
In fact if we see more minutely, there is a "3" in small font after 46 and "1" after 48 i.e. the exact ask/bid rate is 1.29481/1.29463. This extended digit in the quote price is called Pipette. So the exact spread for EUR/USD in this example if 1.8 Pips.
Let us now take an example of not so commonly traded currency pair to see the difference in the spreads. USD/CHF's ask/bid price quotes are0.9343(2/ 0.9340(2) and hence the spread on USD/CHF, at the same time, is 3 pips. Let us now take the example of USD/CNY and USD/INR. USD/INR (U.S. Dollar/Indian Rupee) quotes are 52.98/52.68 and hence the spread on USD/INR is 30 pips. You need a better example? Let us see USD/CNY (U.S. Dollar / Chinese Yuan), it is 6.3070/6.2920 and that brings it to the spread level of 150 pips.
Other Factors Which Affect Currency Spread
Just consider a normal scenario where you are in the shoes of a big broker and wish to sell or buy the same currency at the same time. What will you look at for making profits and minimizing the risk:
- Demand and Supply
Market Hours and Spreads
As we have seen that volatility is an important factor for the liquidity providers or big trading entities, they would like to protect their interests when the markets are very volatile or uncertainty about the price action/direction is too high. For example you may find that the offered spread is high during early morning of Asian session. The reason is simple that the major markets like Japan then Europe and U.S.A. are yet to open and hence the uncertainty factor about the direction of price action is high.
Economic Releases and Spreads
This point also correlates positively with the above point. Current volatility of the price action may be in a normal range but there may be some schedule economic event or news release which is expected to cause some very volatile market moves and the Forex broker may decide to cover that risk of unexpected price movement by increasing the spread.
On face value it seems just a small difference to have 2 pips or 3 pips spread but in the long run it may amount to be a big difference. 1 pip difference over 100 trades is after all 100 pips.
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