Explanation of Forex Spreads and How to Calculate Spreads – To better understand Forex spreads and how they affect your forex trading, you should understand the general structure of every forex trade.
One way of looking at the structure of trading is that all trades are carried out through intermediaries who charge fees for their services. This fee, or the difference between the bid price and the ask price for trading, is called the spread.
Definition of the Bid-Ask Spread
Forex spreads represent two prices: the buy (bid) price for a particular currency pair, and the sell (ask) price. Traders pay a certain price to buy currency and must sell it at a lower price if they want to sell it back soon.
For a simple analogy, consider that when you buy a new car, you pay a market price for it. Once you drive it out of the parking lot, it depreciates, and if you want to turn around and sell it back to the dealer, you have to take less money for it (sell at a lower price). Depreciation accounts for the difference in the car example, while dealer profit accounts for the difference in forex trading.
Forex Market Makers Determine Spreads
The forex market is different from the New York Stock Exchange, where trading has historically taken place in a physical space. The forex market is always virtual and functions more like an over-the-counter market for smaller stocks, where trading is facilitated by specialists called market makers. The buyer might be in London, and the seller might be in Tokyo.
A specialist, one of the few who facilitates trading of a specific currency, may even be in a third city. Its responsibility is to ensure a flow of buy and sell orders for the currency, which involves finding a seller for each buyer and vice versa.
In practice, specialist work involves several levels of risk. For example, it can happen that a specialist receives an offer or buy order at a certain price, but before finding a seller, the value of the currency increases. He or she is still responsible for filling received buy orders and may have to accept sell orders that are higher than the buy orders that were previously agreed to fill.
In most cases, the change in value will be slight, and he will still make a profit. But as a result of accepting risk of loss and facilitating trading, market makers always retain a share of each trade. The part he maintains is called the spread.
Spread Calculation Example
Every forex trading involves two currencies which are called currency pairs. This example uses the British pound (GBP) and the US dollar (USD), or the GBP / USD currency pair. Say, at any given time, GBP is worth 1.1532 times USD. You may believe the GBP will rise against the dollar, so you bought the GBP / USD pair at the asking price.
The asking price for the currency pair will not be exactly 1.1532; it will be a little more expensive, maybe 1.1534, which is the price you will pay for the trade. Meanwhile, sellers on the other hand trade won’t receive the full 1.1532 either; he’s gonna get a little below that, maybe 1,530. The difference between the bid and ask prices – in this case 0.0004 – and that is the spread value. That’s the advantage that specialists save for taking risks and facilitating trading.
Using the example above, the 0.0004 British Pound (GBP) spread doesn’t sound like much, but as the trades get bigger, even small spreads quickly add up. Currency trading in forex usually involves a larger amount of money. As a small Trader, you may only trade one lot of 10,000 GBP / USD units. But the average trade is much bigger, around one million GBP / USD units. The 0.0004 spread on this bigger trade is 400 GBP, which is a much more significant commission.
How to Manage and Minimize Spreads
You have two ways to minimize the cost of this spread:
Trade only as long the best hours and times for forex trading, when many buyers and sellers are in the market. As the number of buyers and sellers for a particular currency pair increases, competition and demand for businesses increases and market makers often narrow their spreads to catch it.
Avoid buying or selling thinly traded currencies. Several market makers compete for business when you trade popular currencies, such as the GBP / USD pair. If you are trading a currency pair that trades lightly, there may only be a few market makers to accept the trade. Reflects reduced competition; they will maintain a wider spread.
And that’s a complete explanation of Forex spreads and how to calculate spreads. Hopefully this article was useful and increased your knowledge about forex trading. Happy forex trading and good luck 🙂