What is spread in forex trading, and what is a good spread? Knowing how spreads work is really important, because they can play a big role in whether or not a forex strategy is profitable. Let’s take a look at the answers to these questions.
What is spread in forex trading?
It’s really simple – the spread is the difference between the bid price and the ask price. It’s measured in pips or pipettes, and it’s basically one of the ways a forex broker gets paid.
The bid and ask price are the prices at which you buy and sell on the financial markets. These prices are slightly different from the actual price of the asset or instrument given by your broker.
When you buy or go long, you pay the “bid” price. This is typically slightly higher than the actual market price.
And when you sell or go short, you do so for the “ask” price. This is typically lower than the actual market price.
In other words, when you place a “buy” trade, you pay slightly more than the actual market price. And when you place a “sell” trade, your sale price is a little bit lower than the actual market price.
How do spreads work?
The best way to answer the question “what is spread in forex trading” is with a really simple example.
Let’s say on GBP/USD, the bid price is 1.17220, and the ask price is 1.17180.
This is a difference of four pips, so of course, this means that the spread is four pips.
Of course, the actual market price of GBP/USD as given by your broker is going to be somewhere in between this – let’s say 1.17200.
So let’s say you enter the market with a buy trade. In the immediate moment after placing your trade, you are two pips down. In order for the trade to be in profit, you need the price to rise higher than the bid price.
And for a sell trade, you enter the market at the bid price, 1.17180, but the actual market rate is 1.17200, which is obviously two pips higher. This is a sell trade, so obviously you need the price to fall lower than the bid price in order to be in profit.
Even though it obviously depends on the size of the trade, 2 pips may not sound like a lot for the broker. However, even on a number of small trades, it quickly adds up. And if an experienced trader places a large trade – let’s say, 10 lots – then that 2 pip spread is a $200 gain, just from that one trade alone. Perhaps now you can start to see how spreads are a broker’s key source of income.
With currency pairs, spreads themselves are usually given in pipettes rather than pips. There are ten pipettes in a pip, so one pipette is one-tenth of a pip.
Here, for example, is the currency pair AUD/CHF – Australian Dollar/Swiss Franc, as seen in the “Quotes” section on MetaTrader 4 for iPhone. The price on the left is the ask price, and the price on the right is the bid price.
The larger numbers are the pips, and the small number at the end is the pipettes. We count pipettes from the fifth place after the decimal point. So of course, the difference between 0.67338 and 0.67342 is 0.00004. Which of course, is 4 pipettes, or 0.4 pips. Easy.
Here is another example, this time involving the Japanese Yen (JPY).
As you probably already know, we count pips slightly differently with the Japanese Yen. We start counting pips from the second digit after the decimal point, and pipettes from the third.
The difference between 95.873 and 95.878 is obviously 0.005. So that’s a spread of 5 pipettes or 0.5 pips – which is exactly what MetaTrader says. Easy!
What is spread in forex trading – spreads and brokers
We’ve already established that, in order for a trade to run in profit, the price of an instrument has to move outside of the spread in the preferred direction. Obviously, what this means for a trader is that the tighter the spread, the cheaper it is for them to trade.
And this is obviously an area where brokers compete against each other in order to get you as a client.
Generally speaking, there are two ways for a forex broker to make money:
- No-commission. Traders do not pay any commission on their trades. Instead, the cost of trading is factored into the spread.
- Raw spread. The broker offers much tighter spreads or in some circumstances, no spread at all. The broker makes its money by taking a commission on each trade. This is usually determined by lot size, e.g., $5 per 1 standard lot traded.
What is the best spread in forex?
The best spread is 0.0 pips, which effectively means that there isn’t any spread at all. The price of selling and buying is exactly the same as the given market price. Once you have entered the market, you don’t need to wait for the price to move outside the spread in the right direction in order to be in profit.
Spreads are by no means set in stone – they are constantly changing, and they can tighten or expand depending on market conditions. They tend to be much wider during times of volatility or expected volatility. This is how brokers offset the risk from sharp changes in price. And they tend to be tighter in high liquidity markets. High liquidity means that it’s very easy to buy or sell something for the desired price. Low liquidity means that there might be a significant difference between the price at which somebody wants to sell something, and the price that someone is willing to pay for it.
Spreads can play a key role in the profitability of a trader’s strategy. For example, a spread of two pips is not going to have a big impact on a swing trader whose trades have a 100 pip profit target. But for a scalper whose profit target may be 5 pips per trade, then a spread of 2 pips is a 40% dent in their return.
In terms of strategy, the currency pair will also play a role. For example, with the major pairs, the trader may be able to count the size of the spread on one hand. But on exotic pairs, the spread could easily be 15-25 pips or even more.
Here’s the perfect example of this, using the exotic pair EUR/NOK, which is the Euro against the Norwegian Krone. As you can see, the spread is 244 pipettes or 24.4 pips! This probably isn’t going to be a currency pair for scalpers!