What Does Spread Mean in Forex
To introduce you in the best way into about spread in Forex I will give you few information’s. I will explain why is there a spread, what it means to you and how spread in Forex affects you. It is one of few Forex basic terms for beginners.
Spreading means something that can extend to some length, width or height. In Forex, spread means cost you pay to your broker can extend to some amount.
Spread meaning in Forex is money, money which broker will make from you when you open an order. Spread is there because broker needs a way how to make money while providing you a service.
There are other ways how broker can make money, like fixed fees, taking other side of the trade, but spread is one of usual ways of their income.
What Does Spread Means To You?
Spread in Forex means to you how much money you will pay to the broker for each trade you open. Each trade you open will be in minus for some amount.
That amount is spread and it is defined by the difference between buy and sell price. Those two prices are called Bid and Ask price.
Here is an example of a chart where you have two prices and the difference between them is spread.
Spread amount you pay on each trade can vary and that depends on the broker, market conditions and currency pair you are trading.
Each broker have its own spread and their job is to offer you the best spread, lowest spread, in order to attract you to become their customer.
Spread for you can mean being profitable or loser on Forex. If you have large spread that means you will need to have higher pip profit target to make money.
When you have low spread it will mean that you will need less pip to be profitable on each trade.
Spread on the Chart
Image above shows you how does the spread in Forex looks like. It is the difference between two prices.
One price(Ask) is the price you will have when you want to buy the currency pair. For example, if you want to buy EURUSD pair you will pay the price $1.13353.
Imediatelly you will be in minus for the amount of the spread. In this case you will be in minus for 0.8 pips.
If you want to sell the currency pair you will get the Bid price. The bid price is $1.13345 at which you will open the order. And, you will be in minus for 0.8 pips like in the case of buy order which I have explained few lines above.
How to Calculate Spread in Forex
So, how to calculate spread in Forex to get the information how much money is 0.8 pips? You need to calculate the pip value to get the value that you will be in minus at the start of an order.
In the table below I have listed lot size you will have in Forex. We will use the case when you use standard lot size where 1 pip is equal to $10.
|Lot size||Units of
|Volume||Pip value in USD|
|1 standard lot||100,000||1.0||1 pip=$10|
|1 mini lot||10,000||0.1||1 pip=$1|
|1 micro lot||1,000||0.01||1 pip=$0.1|
|1 nano lot||100||0.001||1 pip=$0.01|
When you calculate the spread from the example above where we have spread 0.8 pips, we get:
0.8 pip x $10/pip = $8
This means, when you open buy order you will be in minus for $8, which is not small amount.
Now, imagine if the spread is 20 pips. That large spread is on the less liquid pairs, like exotic pairs.
20 pips spread in Forex on standard lot size would be $200 which is large amount. Let’s calculate the spread amount:
20 pips x $10/pip = $200
Know that pip value depends on the lot size you will use on each trade. The example above is for standard lot which is the largest lot size among four I have listed in the table.
If you use smallest lot size, nano lot, then you will have value of 0.8 pips as:
0.8 pips x $0.01/pip = $0.008
Your goal is to make money and not to lose it when you open the order. To prevent that, you need to have small spread as much is possible.
You can use smaller lot size to lower the loss on each pip you have per spread, but you need to know that when you start making some pips you will make less money by each pip.
To be on the safer side and make more money with each pip it is the best to have a broker that will offer you good spread.
Understanding a High Spread and a Low Spread
Typical spread in Forex less than 1 pip is perfect. From 1 pip to 2 pips is ok, and above 2 pips is less attractive.
Anything above 10 pips is something you should avoid if you are day trader.
Now, if you are day trader that means you will trade often. Several trades per day. So, any spread that is larger than 2 pips will give you loss of your money on each trade. When you sum all trades per day you can end up giving a nice sum of money to your broker.
If you are swing trader, a trader that open a trade once a week or two weeks, then a spread of 2 pips will not make a problem to you. Reason is that, that you will try to make money by trading with the trend where orders are usually with several hundreds of pips of profit target.
If you open one trade per week with spread of 2 pips or 5 pips, that costs you, for example, $2 or $5. That will not be a problem because you are looking to make 100 pips which will give you $100 or more.
The Cost of the Spread
Here you can see three examples with three different spreads. Each example is using standard lot size for easier understanding of comparison.
On each chart I have draw a distance between Ask and Bid price to extract the spread amount.
Cost of the Low Spread in Forex – Example
On the chart below I have drawn a lines to explain one spread that is pretty decent. And it is usual spread that broker offers to their traders.
I have used EURUSD pair as an example because it is the pair with lowest spread on the market. Current spread is 1.3 pips.
One test order is open with one standard lot. I have explained above the lot size, so you can take a look what is the pip value of one standard lot.
When I open the order I will be in minus for a spread. At the start I am in minus for 1.3 pip which is for standard lot $13.00. It is initial cost you need to pay. Because you are using variable spread instead fixed cost per trade, this cost can be variable. What is variable cost or variable spread I will explain later on in this post.
If you take $10.000 account and compare it with $13.00 of loss at the start, you can say it is not to bad. That small costs to enter into the trade where you can make $100’s is not to big problem.
Cost of the Medium Spread in Forex – Example
This example shows you GBPNZD pair which have medium large spread in Forex.
Current spread is 3.9 pips which is almost 3x times larger than on the EURUSD pair.
I have open test trade to show you how much you will be in minus when you open the trade.
I have open one standard lot, 1.00, and my current balance tells me that I am in minus for $25.03. That is the cost you need to pay to broker in order to open buy or sell order.
That is quite larger minus compared to EURUSD where I had $13.00.
Large spread makes your start harder if you are hunting for few pips. Your entry costs are high and to cover that cost, you need to trade very well to cover them.
Take a look on the next image with pretty high spread in Forex.
Cost of the High Spread in Forex – Example
I have used exotic currency pair in Forex. U.S. dollar against Polish Zloty, USDPLN.
Current spread on this pair is 20 pips which is high spread. When I open one test trade with one standard lot, I will be in minus for 20 pips.
When I calculate the pip value and calculate the spread, I get minus $50.43. At the start when I open the trade I need to wait 20 pips in profit until I get even. The $50.43 is the cost you need to pay to open order, whether is buy or sell, it does not matter.
20 pips at the start is to high cost and you should avoid using pairs with high spread. If you like to trade these pairs, then you should trade where the profit target should be several hundreds of pips to make it worth trading these pairs.
You have noticed that 1 pip is not equal to $10 when I use standard lot, 1.00. The reason why is that not the same as on the eurusd pair is because pip value is calculated differently when the USD is not second currency in a pair or when there is no USD in a pair.
If you want to learn more you should read How to Calculate a Pip Value That is Not in Your Account Denomination.
The Bid-Ask Spread Defined
How is the bid-ask spread defined in Forex? It is defined as a difference between two prices. Those two prices are the price at which you will sell or buy the pair.
The Ask price is the price you will have when you open buy order. But, the close price of that order will be set to Bid price.
Take a look into the last image above where I have open buy order on USDPLN.
Entry price for buy order is at 3.96825 and you expect the price will move up.
Broker takes defined spread by the Ask-Bid difference, which is 20 pips, and sets the price at which the order will be when you want to close that order.
If you want to close that order you will close it with Bid price. Why is the bid price?
It is because you are selling the pair now. First, you have open Buy order and you bought the pair. Now you have that pair bought. If you want to close order it means you want to get rid of that pair from your portfolio.
To get rid of that pair you need to sell it. That means you will get the Bid price for selling.
This scenario of selling the pair is same as if you would like to open new order, SELL order. You would get the Bid price.
Difference between Bid and Ask price defines the spread and also how much money you will lose if you open and close same order at the same price.
In the case of USDPLN, if you close the order at the price that is shown on the image, you would end up with the loss. The loss would be $50.43.
How to Manage and Minimize the Spread
How can you manage the spread to get the best out of your trading? Meaning, what are the steps you can take to minimize the spread and lower your costs.
First what you can do is to find the broker who can give you the lowest spread. If you minimize the spread on all Forex pair or at least on the ones you will trade, then you will minimize the cost.
Second step you can do to minimize the spread and costs is to select the pair with lowest spread. Do not trade exotic, cross or minor currency pairs. That way you will minimize the spread under 2 pips.
All major pairs, mostly, have the spread lower than 2 pips. Any minor or exotic pair will have spread from 3 or more pips.
By paying attention on these two steps, broker and currency pair, you will manage your risk exposure and you will minimize your costs.
What Affects a Spread in Forex
Forex spread have several factors that can have an influence on it. Those are news that can bring high volatility in the market which can cause the spread to widen.
Second factor can be the currency pair. Is the currency pair attractive or not to traders.
Remember one thing about the spread. If the spread is not fixed, meaning, it is variable and can change its amount of pips, the number of pips in spread will depend on the volatility of the pair.
What that means?
Here is a short explanation of a volatility.
When we say the pair is volatile it means many traders are trading it and the price of that pair is changing very frequently. By frequently I mean, each second the price changes by several pips.
When the price change frequently it means traders are trading it. When traders are trading it, broker makes money on each trade.
If the broker makes money, and I mean, a lot, then the broker will lower the spread for that pair. He will make enough money if he lower the spread. By lowering the spread he will attract more traders and make more money.
The situation where you have a pair that is not so attractive to traders, broker needs to make money by increasing the spread.
Because there is no volatility by traders, he cannot make too much money. By increasing the spread he will make sure he covers the costs for allowing traders to trade that pair.
That is how volatility affects the spread in Forex by trading the currency pair.
News Affecting Spread in Forex
News are another factor that affects the spread in Forex. When the news are published, or even few minutes before and after the news, volatility increases.
Volatility increases because many traders are expecting that the news will bring the desired outcome. The traders are entering the market with expectations the price will move in their favor,
But, because many traders are entering with sell and buy order, the price jumps all around. That volatility increases the spread because brokers needs to accept many orders from traders.
You need to know that mostly brokers works in a way that they accept the opposite side of the trade when the traders open buy or sell order.
When the news hit the market many orders are filled and many order closes because of wrong prediction of a trader. The high volatility in this case is not ok for a broker because of uncertainty. The uncertainty can increase broker costs, so to prevent the loss on many trades in case of news they increase the spread.
That increase can sometimes be from 2 pips to 20 or more pips, depending on the pair.
The solution not being stopped out because of increased spread is to avoid trading before, during and after the news.
Just stay out until the market calms down. That is around half to one hour before and after the news are published.
If you take in consideration that EURUSD pair have around 80 pips change in day, then this four hour change is a lot. On these news the spread change and increases and it is the best to stay out and wait until the market calms down.
You can see the price have increased quickly and then get back where it started to increase. That is the volatility that comes with the news and which affects on spread in Forex.
Imagine what would happen if you open buy order on this situation? You would enter into buy, the price would go up and you would think, great I will make money. And then, the price reverse back and continue moving down where you end with the loss.
That is common situation with news trading.
Types of a Spread in Forex
There is fixed and variable spread in Forex. Variable or fixed spread have pros and cons. Here I will explain each spread type.
What are Fixed Spreads
Fixed spread type is when the broker offers you a spread that does not change. That means, if you make an agreement with the broker you can have spread of 1 or 2 pips.
Fixed spread means that you will have fixed cost for any trade you open. If you open buy or sell trade, you will pay same amount of money to broker.
As an example let’s take situation where the spread is 2 pips. You are opening an order on EURUSD with $1,000 account.
The value of a spread when you open standard lot is equal to:
2 pip x $10/pip = $20
You will have $20 cost each time you open order. This amount will not change.
The limit you will have is that you will not be able to open order when the news are published. Broker can make an statement in your contract that they cannot allow trading in case of high volatility news. The reason is, they want to protect themselves from losing a lot of money.
What are Variable Spreads
Variable spread type is a standard spread that many traders use. It is spread that changes occasionally.
The spread change can be in a minute or few hours. That depends on the broker. The broker tends to change the spread as rarely as possible.
No one likes to have variable spread that changes a lot. All traders like to know how much the spread will be on the trade they will take.
Variable spread will change when the news are published or when the market volatility is low.
Volatility decrease each night on some pairs because many traders are sleeping at night. When the market opens in the morning the volatility increases and the spread decrease.
Variable vs. Fixed Spreads in Forex
Which one to select, fixed or variable spread type depends on your preferences and cost you can pay. Fixed spread type you need to pay with some fee where the variable spread type does not have additional costs.
Here are the pros and cons for fixed and variable spread type.
Fixed Spread Type:
- Fixed spreads allow traders to rely on a fixed cost on each trade.
- Fixed spread type is not available for scalping
- You can have re quote when opening an order because broker cannot adapt their offer to new market conditions
Variable Spread Type
- There are no re quotes
- Spread can be lower than fixed spread in some cases
- Spread can change in seconds depending on market conditions
- It can trigger stop loss in case of large movements which can lead to losing a trade that could be profitable
How Forex Brokers Profit From Spreads
There are two ways how the broker makes money from your trading.
One way is through spread they are charging you each time you open the trade. That cost can be small or high and it depends on the spread.
If you trade a lot they will make more money with each trade you open. If you trade when the spread is wide, they will make more money.
Second way how the broker makes money is by taking the opposite side of the trade. THat means when you want to buy the pair the broker will sell it to you.
When the you want to sell pair the broker will buy it from you.
When you take in calculation that over 75% traders are losing money by trading on Forex, you can understand how brokers are making majority of their income.
This should not bother you, thinking that they are fighting against you and they want you to lose the money.
Broker wants you to trade so they can make money through spread. If you trade and lose money they make money.
By providing the service to you, and that is alowing you to access to the Forex market, they allow you to make money. Your goal should be to trade profitably and not to worry about broker earnings.
Forex Spread Indicators
Forex spread indicator shows how the spread changes in time. How the time passes on the chart you can have a two lines that shows the difference between Ask and Bid price.
The two lines that represents Bid and Ask price can get close to each other which means the spread is lower. When those two lines move away from each other it means the spread is increasing.
This type of indicator for spread can be useful if you want to see how the spread has changed in the past. You can find some patterns when the spread is narrow and wide to determine the best time to open a trade and lower the costs.
The indicator could show on major pairs that the best time is when large trading sessions overlap, like London and New York.
At that time we have many traders active and volatility is high which will lower the spread on the market.
Forex spread is one thing you need to pay attention to. It is the cost you will have on each trade you open.
Your goal should be to lower the costs and that is by trading with the broker that offers lowest spread and to find the pair that has the lowest spread.
Spread is the difference between Ask and Bid price and it can change how the volatility changes. To avoid fluctuations on the spread you can choose fixed spread type instead variable spread type. That way you will know how much cost you will have on each trade you open.
When selecting the broker, use the one that is regulated and that offers the lowest spread. Have in mind that broker that have the lowest spread is not the best broker. Not always, but you can find decent broker with decent spreads that are acceptable.
If you are looking for a broker you can check the one I am using. Take a look on the GetKnowTrading broker.