Understanding a Forex Spread - What Do You Need to Know?
- Trading Systems
- 14.01.2022 11:40 am
For those who aspire to become successful traders, learning how trading works and gaining a theoretical understanding of the markets is of paramount importance.
It’s this that helps to create viable and relevant trading strategies, while also cultivating a sense of determinism that enables you to recognise the underlying laws that govern change in the forex market.
This understanding should also extend to include market fundamentals such as the so-called “forex spread”. But what exactly does this refer to, and how is the spread calculated in the foreign exchange?
In simple terms, the process of investing in the forex market involves trading one international currency in exchange for another at a predetermining and floating exchange rate.
Because of this, currency pairs are quoted in terms of their price in another currency, with the forex spread referring to the difference that exists between the aforementioned exchange rate at which a broker sells the currency and the rate at which it is purchased.
In more simplistic terms, the spread refers to the difference between the bid and ask price of a currency pair, with this usually measured in pips and malleable to a variety of market factors and economic events (we’ll have a little more on this later in the piece).
Certainly, you’ll find that a forex spread can be impacted directly by political events and wider macroeconomic factors, especially changing base interest rates and fluctuating rates of inflation across the globe.
Now that we understand the broad definition of a spread and precisely how currencies are quoted in the forex market, the next step is to determine how spreads are calculated in the first place.
We’ve already touched on the bid and ask prices, which are central to this process and determining the spread in real-time.
The bid value represents the price at which a broker is willing to buy the base (first) currency in exchange for the counter (or second) currency. Conversely, the ask value refers to the price at which a broker is willing to sell the base currency in exchange for the counter currency, determining the initial spread in the process.
So, if a customer initiates a sell trade with their chosen broker, the bid price will be quoted first. If a buy trade is initiated, the broker will quote the ask price directly.
For example, let’s say that a US investor wants to go long or invest in Euros. In this instance, the bid-ask price on the broker’s site is $1.1200/1.1250, and to initiate a buy trade the investor will be quoted the ask price of $1.1250.
If the investor subsequently changed his mind and immediately decided to sell back the Euros to the broker (closing the position in the process), the investor would be quoted the bid price of $1.1200 per Euro.
Assuming that no price fluctuations occurred during this period, this type of speculative trade would cost the investor $0.050 in total, due solely to the exchange rate’s bid-ask spread between client and broker.
The last consideration should focus on the various factors that impact the spread, aside from the aforementioned political events and macroeconomic factors.
Take the time of day when a trade is initiated, for example, with the typical spread for a Euro of GBP trade likely to be much wider and more costly during the Asian trading session. This is due to demand and lower liquidity levels, so it’s important to keep this in mind when planning your activity as a trader.
Ultimately, the key takeaway here is to plan your trades carefully and factor in the spread as a crucial part of your strategy, particularly from a risk-management perspective.