What Does Spread Mean in Forex?
Spread has an enormous impact on the profitability of forex trades. Learn everything you need to know, below.
Tim Fries.
Tim Fries is the cofounder of The Tokenist. He has a B. Sc. in Mechanical Engineering from the University of Michigan, and an MBA from the University .
Reviewed by.
Shane Neagle.
Shane Neagle.
Meet Shane. Shane first starting working with The Tokenist in September of 2022 — and has happily stuck around ever since. Originally from Maine, .
Updated June 14, 2022.
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Is guacamole superior to peanut butter and jelly?
Just kidding—those aren’t the sort of spreads that we’ll be dealing with today (though I would certainly opt for the guacamole). ��
Spreads are an essential part of forex trading—and at first glance, they might seem a bit daunting. They change rapidly, involve math, and worst of all, multiple decimal places. They look indecipherable—but if you put in a little effort, they’re actually quite easy to understand.
Forex trading isn’t simple. Although we’re witnessing an explosive rise in the number of new traders, the fact remains that over 70% of retail traders, meaning individuals, end up losing money in the foreign exchange market.
But these losses can be avoided, provided that you put in the work to educate yourself. And we’re here to help—this guide will cover all the basics, as well as a few more advanced points to help you along on your forex journey.
We’re going to explain what spreads are, how they work, what causes them to fluctuate, as well as what type of spread is best suited toward your needs—and we’ll do it all in simple, easy-to-understand human language.
Once that key stepping stone is in place, you can continue with your forex education, open a demo account—and hopefully, eventually succeed where most fail. ��
What you’ll learn.
What's a Spread? Difference Between High and Low Spreads Test Your Knowledge: Quiz Different Types of Spreads in Forex Fixed Spreads Explained Variable Spreads 101 Calculating Spread Cost How Are Forex Spreads Quoted? What’s Behind Forex Spreads? Scalping and Managing Spread.
What’s a ‘Spread’ in Forex Trading? ��
A majority of forex trading is done without commissions. This is great, no question about it, but it does pose another question—how do brokers make money if that is the case?
The answer is through spreads. A spread is a built-in transaction cost that brokers use to make profits off of trades. A broker will sell you a currency at a higher price point than they buy it for and they will also buy it from you for a cheaper price than they sell it for.
There’s no reason to be alarmed here—spreads are usually small, and most forex brokerages have shifted to this business model. If a brokerage offers zero commissions and 0.0 spread, beware—it is most likely a scam forex broker. So, now that we’ve described spreads in simple terms, let’s go a little more in-depth.
When you log into your forex broker platform of choice, you will see two different prices for any currency pair—the bid price and the ask price. The bid price determines at what price you can sell the base currency, and the ask price determines for how much you can buy the base currency.
As we’ve discussed, the ask price is always higher than the bid price. The difference between the two is the spread and that difference is measured in pips—the smallest amount by which a price can change. And seeing as how most currency pairs are quoted to the fourth decimal place, a pip is (usually) equal to 0.0001.
If this is all becoming a little confusing for you, the image above should help you visualize it. Take the ask price of 1.1074, subtract the bid price of 1.1071, and voila! There’s your spread of 3 pips. That’s how forex brokerages profit from traders, and it’s a cost that you’ll have to factor in for each trade in order to come out on top.
Now that we’ve got the basics down, let’s move on to a few more complex topics. Namely, high and low spreads, the different types of spreads, and how to calculate spread cost.
Spread Overview and Summary.
Spreads are the difference between the bid price and the ask price of a currency pair. Spreads are the most common way that brokerages make a profit. A spread is measured in pips—a unit of measurement that is equal to 0.0001 for most currency pairs. For currency pairs involving the Japanese Yen, a pip is 0.01 Spreads change throughout the day, sometimes quite rapidly—you’ll have to keep an eye out for low spreads to make good trades. Spreads can either be fixed or variable, depending on what brokerage you’re using.
Difference Between High and Low Spreads ��
Before we move on, let’s deal with the topic of high and low spreads. You might be thinking to yourself: “Well, if spreads are just a fact of life in FX trading, something like a commission, then there’s not much I can do about that—so I shouldn’t pay any mind to that stuff”.
And you’d be wrong—the difference between a high spread and a low spread can have a huge effect on your trades and whether or not they’re profitable. Keep in mind that you’ll have to cover the cost of the spread.
What this means in practice is that in situations with a high spread, it is much tougher for a trade to become profitable—and it takes a lot longer, which is far from ideal.
Testing Your Knowledge: Quiz Time ��
We’ve gone over how spreads are calculated but taking a few moments of your time out to apply that knowledge will be beneficial in the long run. Here’s a short quiz that will help cement this knowledge firmly so that we can move on.
1. Currency pair: GBP/USD.
Bid price: 1.3581.
Ask price: 1.3584.
What’s the spread?
Answer: Spread = 3 pips.
2. Currency pair: NZD/USD.
Bid price: 0.7135.
Ask price: 0.7142.
What’s the spread?
Answer: Spread = 7 pips.
3. Currency pair: EUR/USD.
Bid price: 1.20775.
Ask price: 1.20791.
What’s the spread?
Answer: Spread = 1.6 pips.
4. Currency pair: EUR/CAD.
Bid price: 1.53834.
Ask price: 1.53851.
What’s the spread?
Answer: Spread = 1.7 pips.
Different Types of Spreads in Forex.
Not all spreads are created equal. In fact, the way that spreads are determined varies from one broker to another. There are two types of spread in forex— fixed and variable .
The difference between the buy and sell price of a currency pair in a variable spread fluctuates in range, whereas the fixed spread remains constant regardless of the circumstances.
Before you go ahead and open an account with a forex broker, you’ll want to find out what the differences between fixed and variable spreads are, and which of those options is more appealing to you. In this next part, we’ll go over the key differences, as well as the advantages and disadvantages of both options.
How Do Fixed Spreads Work? ��️.
Put simply, fixed spreads stay the same regardless of what is going on in the market. This system is utilized by market-maker and dealing desk forex brokers. This means that the difference in the bid price and the ask price is constant, taking a lot of the guesswork out of the equation.
Pros and Cons of Fixed Spreads ����
Fixed spreads are consistent, and therefore much more predictable. Some of the main advantages of fixed spreads are:
Predictable trading costs Smaller capital requirements They are better suited for novice traders.
They’re much more appealing to beginner traders and offer predictable trading costs, as well as smaller capital requirements. But they also come with a couple of drawbacks, including:
Requotes Slippage Higher overall spread.
Requotes occur when prices change so fast that the broker can’t adjust the spread in time to adapt to newfound market conditions. When this happens, your trade will be blocked, and you will be given a new, requoted price which you can then accept or decline. This is nearly always a price that is significantly worse than the initial one.
Slippage is a similar problem—but in the case of slippage, your order is filled at a price that is different from the requested price. This might be OK, but also might be bad for your profits.
What About Variable Spreads? ⚙️.
Variable spreads are utilized by non-dealing desk brokers. They have no control over the spreads that they offer—instead, they get the prices from a number of liquidity providers and then simply pass them on.
Variable spreads are constantly changing—you might think that this is risky, and it definitely can be. But spreads can also become narrower—much narrower, in fact, than what a fixed spread broker could ever offer.
Pros and Cons of Variable Spreads ⚖️.
In contrast to fixed spreads, variable spreads aren’t all that consistent and predictable. However, they do offer a couple of key advantages when compared to fixed spreads that include:
Better and more transparent pricing Generally tighter spreads No requotes Faster trade execution.
So, what about the cons? Well, some of the more significant ones are:
Larger capital requirements Less suitable for novice traders Spreads can rapidly increase due to volatility Not suited to scalpers and news traders Slippage can still occur.
Is it Better to Trade Forex with Fixed or Variable Spreads?
There’s no one-size-fits-all answer here but there are a couple of things that generally hold true. If you’re trading infrequently or with a small account, fixed spreads are the way to go. On top of that, if you’re planning on scalping or news trading, then fixed spreads are the better choice.
Fixed spreads are generally better for novices who are learning how to trade forex because they provide a more forgiving learning curve, as well as a more predictable, consistent experience. The high volatility we’ve seen during COVID-19, or any volatility for that matter, doesn’t present as much of a problem as it does with variable spreads.
If you’re a more experienced trader, have a larger account, or simply need lightning-fast execution, variable spreads are the superior option. They also offer the benefit of extremely rare requotes—something that high-volume traders will appreciate. This is why most of the top forex trading platforms, among others, include an account with variable spreads.
Calculating Spread Cost ➗
So, now that we have the basics down, we are left with a few questions—what is a spread and what types of spreads exist? Also, how do spreads actually relate to your trading costs in real terms?
To calculate the actual cost of a spread, you’ll need two more things—the value of a pip, and the number of lots that you’re trading.
For example, let’s say that we’re trading EURUSD, dealing with a spread of 0.4 pips, and trading with a mini lot, which is 10,000 units. Because the US dollar is the quote currency (listed second), pip values are fixed. In this case, for a mini lot, a pip is worth $1.
So we take 0.4 pips, or 0.00004, and multiply it by 10,000, and then by $1. Put differently, 0.00004 x 10,000 = 0.4. We take 0.4, multiply it by $1, and we get a spread cost of 0.4$.
How Are Forex Spreads Quoted? ��
In all cases, forex quotes have both the bid price and the ask price of a currency pair. Since the spread is the difference between the two, finding out the exact size of the spread is just a matter of calculation.
For example, if GBP/USD is listed with a bid price of 1.3587 and an ask price of 1.3594, the spread is 7 pips. But you might not even need to do the calculations yourself—a lot of forex brokers have a spread indicator built into their user interfaces.
What’s Behind Forex Spreads? ��
There are two main factors that influence spreads—liquidity and volatility. High liquidity, which means high trading volume, causes low spreads. The inverse is also true—when liquidity is low (as is often the case with minor currencies) the spread widens.
Low volatility leads to small spreads, while high volatility leads to larger spreads. But these are just two factors—many things can have an effect on spreads. So, what are the main causes of spread fluctuations?
First of all, timing matters. The forex market operates 24-hours a day on workdays, but it is decentralized—having three major sessions centered around the global hubs of foreign exchange trading. These are the Tokyo, London, and New York sessions.
Unsurprisingly, when a session is in progress, the currency that is associated with the country in question will see an increase in trading volume, leading to lower spreads. For example, trading the Yen, which has seen gains in the past couple of months, is best done during the Tokyo session.
Spreads are generally the lowest when trading sessions overlap, which is why timing your forex trades to them is a great way to make more profitable trades.
Other than timing, the news can also have a large effect on spreads. Particularly if the news is related to politics or the economy—geopolitical instability and unexpected economic events like the COVID-19 pandemic can have sudden, drastic effects on spreads.
Trade balances, unemployment numbers, interest rate decisions, industrial production… all of these data points will have an effect on spreads when released. Keeping an economic calendar close at hand can help you make the decision whether or not to trade—but no one can accurately predict the news, so these changes are just a fact of life when it comes to forex trading.
Is Scalping a Method of Managing Spread? ��
Scalping refers to a popular strategy for trading forex in which a large number of small trades are executed in a short period of time to make use of minor price changes. Usually, most scalpers make 1- to 15-minute trades, aiming to scalp between 5 and 10 pips per trade.
Scalping is a trading strategy—but it is not a method of managing spreads. There isn’t actually a way to manage spread apart from trading at the right time, keeping an eye on an economic calendar and current events, and focusing on currency pairs that exhibit high liquidity, which is to say the major pairs. What are the major pairs, you ask? It’s simple – they’re currency pairs that include the US dollar – which has been performing quite well as of late.
Conclusion.
Having a rock-solid grasp of spreads is key to successful forex trading, no matter which strategy you pick. Spread can seem daunting—it can change rapidly, eat up your profits, and cause requotes—but all of these issues can be alleviated if you take the time to really get into the subject matter and apply yourself.
We hope that this guide has managed to shine a light on the topic of spread and that it managed to give you some confidence for the long road ahead. Take your time, take things at your own pace, and put in the work. If you’re concerned about the impact of the COVID-19 pandemic on the forex market, don’t worry—the forex market has managed to perform unexpectedly well overall.
Rushing in won’t do you any good—study hard, open a demo account, and start off slow with fixed spreads. Slow and steady wins the race when it comes to forex trading. There’s little room for error with this type of trading, so do your best to master each and every topic before you move up the ladder.
And if you feel confident that you’re ready for more, you’ll find plenty of educational guides, as well as reviews of forex brokers on our site—so dive in.