To be able to gain a better insight into forex spread and the way it may affect you, you should be able to understand the basic structure of a forex trade. A perspective into the trade structure is that literally all the trades are accrued by intermediaries who require a commission or a fee for their services. This fee or charge is essentially the trade’s difference between the bid and ask price known as the spread.
Bid-Ask Spread Defined
Forex spread indicates two rates: the buying bid price for a certain currency pair and the sell or the ask price. Traders pay a particular price to purchase the currency and they would have to sell it for a low rate if they wish to sell it back immediately.
Understand this with a basic analogy: you pay the market price for a new car you buy. The second you drive it away its value begins to depreciate and if you wish to sell it back right away, you will still get a lower price.
Calculation example
Each forex trade takes place with two currencies together known as a currency pair. Here we will talk about the British Pound (GBP) and the U.S. dollar (USD)—or the GBP/USD currency pair. Let’s assume that at a certain point of time, the GBP rate is 1.1532 times the USD.
You might feel that the GBP rate will increase against the dollar and hence you end up purchasing the GBP/USD pair at the ask price.
Now the ask price for the currency pair will not equal 1.1532. It would be slightly higher at perhaps 1.1534—and this would be what you pay for the trade. On the other hand, even the seller will not be getting the full amount of 1.1532 either. They’d get something around 1.530.
In this case the difference between the bid and ask prices—in this instance, 0.0004—is the spread between the trades.
Though the spread might not seem like much at first, remember that a .0004 profit equates to four pips which would be $40 profit for a standard lot of EUR/USD. The intermediary is able to make a considerable amount of profit by facilitating thousands of these trades everyday.
If you are a retail trader, you might be copy trading only one 10,000-unit lot of GBP/USD. But if the average trade happens to be much larger, say somewhere around one million units of GBP/USD, imagine what the 0.0004 spread in this larger trade would look like. A 400 GBP in this scenario is a significant commission.
What is a good spread?
You should observe the most liquid forex pairs to understand what a good forex spread looks like. USD/JPY and USD/GBP are two of the most popular forex pairs in the market. You may want to look at those pairings’ spreads in comparison to that of other pairings. You may even find it helpful to check differences in the spreads between various brokerages to make sure you’re getting the best deal that’s out there.
High spreads imply that a particular currency pair is less liquid than others. This means that not a lot of traders are putting their money on this pair. The lower the number of traders who focus on a currency pair, the lesser are the chances of you finding a buyer who will provide the price that’s near the opposing side of the trade. The spread increases when the trading is infrequent. Trading companies tend to include trading fees in the spread and go on to market themselves as a “commission-free” trading platform.
How can the spread be minimized?
There are two ways of bringing down the cost of these spreads:
- Conduct the trades only when trading hours are known to be very favourable and when there are several many buyers and sellers in the market. When there are more buyers and sellers for a given currency pair, it boosts competition and demand for the business increases. As a result, market makers may end up squeezing their spreads to get onto the trend.
- Avoid carrying out transactions on currencies that are not traded frequently. There are a number of market makers who compete for business whenever popular currencies like the GBP/USD pair are traded.
What are the drivers for a Forex spread?
There are other factors too that can cause a forex spread to widen or narrow down
Time of Day
At what time of the day a trade is initiated makes a difference. For instance when European trading begins, it is still early for U.S traders while Asian markets open late for them at night.
Thus, if it is not a regular trading session for the currency, you will not find a lot of traders and hence there will be low liquidity. An illiquid market implies that there are not enough participants and hence currency cannot be bought or sold with ease.
Events and Volatility
Economic and geopolitical events can also cause forex spreads to widen. Say if the unemployment rate turns out to be higher than expected, then the position of the dollar would weaken or begin to lose value. The forex market could move suddenly and can turn out to be volatile in case of unforeseen events. Since exchange rates can fluctuate rapidly, forex spreads could be much wider when such events occur.
Pairs worth trading for the best spread-pip potential
If a trader is actively day trading and focusing on a certain pair, it is most likely they will trade pairs with the lowest spread as a percentage of maximum pip potential.
If someone is an active day trader and is emphasizing on a particular pair, it is certain that they will pick the currency pairs that have the lowest spread as a percentage of maximum pip potential.
- The EUR/USD and GBP/USD will be showing the best ratio of the pairs.
- The USD/JPY is also highly ranked
- While GBP/USD and EUR/JPY have a four-pip spread, they tend to surpass USD/CAD, which comes with an average of a two-pip spread. Rather, the USD/CAD trade comes with a spread that accounts for a rather large portion of the daily average range.
