What is the spread?
The spread is an inevitable part of trading and is the profit taken by the broker. When trading Forex, whether through a Forex account or using spread betting, the broker does not charge you a fixed or monthly fee for operating the account. The broker does not take any direct transaction charges for taking a trade either. Instead, the broker offers two different prices for a currency trade, often referred to as the bid price and the offer price. These are the brokers prices, describe what the broker is doing, the broker is bidding and offering. You buy at the offer price and sell at the bid price. The difference is called the spread and is the brokers profit margin.
These are the prices at which I can buy and sell Eurodollar, the currency pairing of the Euro and the US Dollar. The price you can sell them to the broker is 1.2612. This is the bid price, or what the broker is bidding to buy your currency. When looking at Forex charts, it is most common to have the bid price displayed. If you wanted to buy this currency from the broker, you would have to pay 1.2614. This price is called the offer price, or ask price, or the price the broker is offering to sell you the currency.
There is another price called the mid price. The mid price, as it’s name suggests, is the middle point between the two prices. Take the bid and offer price, add them together and divide by two to obtain the mid price. The mid price is not often used, as you can’t actually trade at this price. It may be useful when the market is very slow or volatile. Currency movements are measured in pips. The spread is the difference between the bid and offer prices and is expressed as a number of pips.
To calculate the spread, move the decimal point four places to the right and simply deduct the bid price from the offer price. In this example, Eurodollar is trading with the spread of 2 pips. When you look at a price chart based on the bid price, you need to add the spread to the bid price whenever you are contemplating buying the currency to find your true cost. Spreads on different currency pairs vary. The calculation is the same, so move the decimal point four places to the right and deduct the bid price from the offer price to obtain the spread. Cable is trading here with the spread of 3 pips.
On some of the less commonly traded currency pairs, it is normal to see spreads a lot higher. Here, the Kiwi Dollar and the Swiss Franc are trading with the spread of 7 pips. You might decide this is too high for you to trade. Your might restrict the currency pairs you trade on certain strategies as a result of the spread. When it comes to trades involving the Japanese Yen, the decimal place is moved two places to the right to calculate the spread. In this case, the Aussie Dollar is trading against the Japanese Yen with a 4 pip spread. Competition amongst brokers is fierce and often seen in their advertising by the spreads they quote.
Eurodollar is the most heavily traded currency pair and usually has the tightest spreads. Brokers are keen to let you know how tight (or narrow) their spreads are on Eurodollar. From 2 pips, there are not many steps down to zero, so many brokers have moved to pricing at 5 decimal places. To calculate the spread still means moving the decimal point 4 places to the right. In this example, the spread is 1.3 pips. The equivalent for pricing the Japanese Yen is to quote the price to three decimal places. The decimal place is still moved two places to the right to calculate the spread, which at this moment is 2.8 pips.
Most brokers now use variable spreads. This means the broker can change the spread at will. During periods of normal trading, this leads to very competitive spreads. When trading is “thin” , which means not very much activity, brokers often widen their spreads. This can sometimes be seen at the beginning of the week when the market is opening and at the end of the week when it is about to close. Given spreads are variable, it can mean the bid and offer price moving quite independently of each other. This can also happen at times of high market volatility. Although the spread is the brokers cut, it is not generally seen as a transaction cost.
When trading, the focus is on the bid and offer prices at the moment in time when the trade is executed. You can see the impact of the spread at the precise moment you take the trade. For example, trading Eurodollar at £2 per pip with the spread of 1.1 pips results in a cost of £2.20. Rather than focus on this cost, you will be looking at the P&L as the trade progresses and either the net profit to you, or the total cost.
A quick recap on spreads. Spreads on currency pairs vary by currency pair. Most traders focus on the major currency pairs for trading, as the spreads are more competitive. Competition amongst brokers is fierce. Don’t assume all brokers give the same bid and offer prices, or the same spread. If you have multiple trading accounts, shop around. Market conditions can affect spreads. Most brokers use variable spreads allowing them to take advantage of slow markets.