What is the Spread in Forex and How do you Calculate it?
Reading Time: 18 Minutes
Trading in the foreign exchange market (also known as Forex trading or FX trading) refers to exchanging one currency for another. The Forex market is one of the most actively traded marketplaces in the world. Individuals, global corporations, and commercial banks engage in this market daily. According to the BIS Triennial Central Bank Survey, trading in OTC FX markets reached US$7.5 trillion per day in April 2022, up 14% from US$6.6 trillion three years earlier. Reports also show that currency exchange is primarily dominated by FX swaps, followed by FX spot transactions and outright forwards.
There are a number of variables that influence currency volatility, such as monetary policy orchestrated by a nation’s central bank, market sentiment, and geopolitical effects. Currencies can, therefore, vary in their price movement and daily range.
A Forex pair, or currency pair, consists of two currencies traded against each other. A number of possible combinations exist; some of the most popular currency pairs involve the US dollar (namely major currency pairs): the US dollar against the Japanese yen (USD/JPY), the British pound against the US dollar (GBP/USD), and the euro against the US dollar (EUR/USD).
A currency pair's base currency appears on the left side of a currency quotation, and its quote currency (or term currency) exists on the right side. The quote currency is equal to the current quote price of the pair, and the base currency is always equivalent to 1 unit of currency. The quote currency informs market participants how much 1 unit of the base currency is worth in terms of the quote currency. Consequently, selling (buying) 1 currency to buy (sell) another is a constant in currency trading.
Defining Spread in Forex
Spread is the difference between the Bid price (sell) and the Ask price (buy) of a currency pair in Forex trading. The Bid price is the price at which the base currency can be sold, whereas the Ask price is the price at which the base currency can be purchased.
As stated, the base currency is displayed on the left, and the quote (term, or counter) currency is displayed on the right. The quoted buy price (Ask) will generally always be greater than the quoted sale price (Bid), with the market price (fair value) falling somewhere in between. Due to greater liquidity (more willing buyers and sellers) and trading volume, major currency pairs will often have lower spreads compared to other currency pairs: minor and exotic currency pairs.
As an illustration, the Bid and Ask rates for the EUR/USD currency pair, in this example, is $1.1251/1.1252. The base currency is the euro (EUR) and the quote currency is the US dollar (USD). As a result, a retail trader can sell the EUR at the Bid of $1.1251 or buy the currency at the higher Asking price of $1.1252. The spread in this example is 1 pip (percentage in point). This is the smallest whole unit of movement in an exchange rate. For example, the EUR/USD rising from $1.2500 to $1.2501 equates to a 1-pip move higher and is calculated by taking the difference between the Ask price and the Bid price, commonly referred to as the Bid/Ask spread.
Types of Forex Spreads: Fixed VS Variable
Fixed spreads, in contrast to variable spreads, are predetermined by the broker and remain constant, independent of market volatility or conditions. You'll notice that the spreads for different currency pairings can differ substantially. However, the spreads for the major currency pairs could be as low as a 1 to 2-pip spread, while for minor and exotic currency pairs, the spreads can be much wider due to liquidity issues.
Fixed spreads provide an obvious benefit in volatile trading conditions.
As its name implies, a variable spread constantly shifts. It is essential to understand that brokerages receive spreads from their liquidity providers and effectively transfer them to the trader. Consequently, supply and demand for a specific currency and market volatility can affect variable spreads.
Fixed and variable spreads can, of course, produce different outcomes in terms of profit and loss. Spreads can also be a factor in the trading style adopted. For instance, short-term traders, such as scalpers and day traders, may use fixed spreads, particularly in volatile trading conditions.
Conversely, long-term traders, such as swing traders and position traders, can afford to accommodate more slippage (the difference between the expected price in which the trader executes the trade and the price received) and therefore tend to work with variable spreads as they’re often smaller than fixed spreads.
The bottom line is that when there is a lot of liquidity in a market, variable spreads are typically more cost-effective than fixed spreads. However, variable spreads can swiftly expand during periods of excessive volatility and when significant news events occur.
How Are Forex Spreads Calculated?
The spread in the Forex market can be calculated based on the measurement of a pip: the smallest whole unit of measure for any specific currency pair. 1 pip is equal to 0.0001 (or 1/100th of a pip) and is the standard unit of measurement for most currency pairs. The exception to the 0.0001 format is the Japanese yen (JPY), quoted to two decimal places.
To calculate the spread, we need to take the difference between the current Ask price and Bid price. For example, if you're trading GBP/USD at $1.1041(Bid)/1.1043(Ask), the spread is calculated by taking the difference between $1.1043 (the Ask) and $1.1041 (the Bid), which is 0.0002 (or 2 pips).
A point or fractional pip is important to understand, equivalent to 1/10 of a pip. The fractional pip is quoted at five decimal places for most currency pairs, while for the JPY it will be seen at the third decimal place.
GBP/USD $1.10431< Point
For those who prefer to use a Forex calculator in their trading operations, helping to compute aspects such as pip value, swap rates and position size, FP Markets, a fully regulated Forex and CFD broker, provides a comprehensive calculator
How Does a Broker Generate Revenue?
Traders and investors engage with different currencies based on their predictions (usually through technical and fundamental analysis). The foreign exchange market can be high risk for new traders. Therefore, a good risk-management plan is also important.
Traders go through an intermediary, such as a Forex broker, to execute trades. Forex brokers generate revenue through commissions and fees. The spread represents a large portion of their revenue as brokers buy at one price (this is your Bid price) and sell at a higher price (this is your Ask price). Understanding trading costs and how Forex brokers operate can help you choose the right broker. A responsible broker will have a transparent fee structure readily accessible to the trader.
How Are Forex Spreads Quoted?
Because traders and investors are unable to buy (sell) one currency without selling (buying) the other, all currency values are quoted in currency pairs (for example, USD/EUR or AUD/USD).
If the AUD/USD exchange rate is $0.7500, this indicates that the value of 1 Australian dollar is valued at $0.75 in terms of US dollars. The value of the base currency is always 1 unit of the currency, regardless of the circumstances. If the value of the AUD/USD pair increases, this informs market participants that the base currency has become stronger while the quote currency has declined in value. If, on the other hand, the value of the AUD/USD currency pair depreciates, then the base currency has become less valuable while the quote currency has gained in value.
Forex Spread Indicators and How to Use Them?
Most spread indicators available for download are linked to Forex brokers. Spread indicators for MetaTrader 4 (MT4) are a helpful instrument for those who trade foreign exchange, usually displayed in the form of two basic undulating curved lines, or sometimes a histogram. However, several different displays are available, dependent on the Expert Advisor (EA) selected. Consider checking out the MetaTrader library here: https://www.mql5.com/.
Organically Viewing Spreads in MT4:
- Launch MT4 through a trading account (either a demo account or live account) provided by FP Markets.
- Navigate to the view tab, scroll down and select Market Watch.
- Right-click on any pair in the Market Watch pane, which will generate various options. Subsequent to this, scroll down and select spreads. You will be presented with the Market Watch pane as shown in figure 1.A.
- If you are a beginner trader, this could be an appropriate time to familiarize yourself with the Market Watch window and all its available features.
Viewing the Bid and Ask Spread Lines on an MT4 Chart:
We can apply this in four simple steps:
- Launch the MT4 trading platform.
- On any chart, right-click and then select Properties (F8) to choose your color for the Ask line.
- Following step 2, select the Common tab and ensure that the Ask line is selected and then select OK.
- The colors you select will be applied to the Ask line. If you are a scalper or day trader who needs to monitor charts for spread fluctuations, these lines will be readily visible on the lower timeframes.
Factors that Drive Forex Spread
The foreign exchange market, known as Forex, is a globally decentralized marketplace for currency trading. Liquidity and volatility are two primary factors influencing the spread distance between the Bid and Ask prices of currency pairs. Liquidity tends to decrease ahead of risk events (economic indicators including the Gross Domestic Product [GDP], inflation, trading volume, and unemployment) which can widen the spreads traders receive as there are less willing buyers and sellers in the market. Spreads can also drive Forex accounts to margin calls if the spread widens drastically.
As well as economic indicators, political stability, and central bank policies are some of the main variables that influence the spread of the Forex market.
If you're looking for a good broker, FP Markets is a fully regulated broker that offers an education section and a comprehensive guide to how spreads work. Also, some of the tightest variable spreads are available with FP Markets.
You can also trade a number of different asset classes using CFDs in Forex, shares, indices, commodities, bonds. metals, and digital currencies, all under the umbrella of FP Markets.