Spread is a key concept for Forex market trading. It is the difference between the buy and sell rates and is essentially the cost that traders incur when making a trade.
The spread replaces regular commissions because leveraged trading providers include it in the total cost, recognizing the constant discrepancy between the buy and sell prices.
Each currency pair in Forex has two different prices - the bid price, or selling rate, and the ask price, or buying rate. The base currency is located on the left side of the pair, while the variable or quoted currency is located on the right side. Notably, the quoted bid price is invariably higher than the quoted ask price, and the real market price is somewhere in between these two values.
Unlike many other financial instruments, most Forex currency pairs are traded without direct commissions. Instead, the commission associated with any transaction is the spread - in keeping with the fundamental principle that the bid price invariably exceeds the ask price.
The spread is measured in pips, which is the minute unit of change in the price of a currency pair. It is usually denoted as the last decimal place of the exchange rate (0.0001). However, it should be noted that Japanese Yen pairs follow a different convention where the spread is measured by the second decimal place (0.01). A higher spread indicates lower liquidity and higher volatility, while a lower spread indicates higher liquidity and lower volatility.
The nature of the spread in Forex trading can be categorized as either variable or fixed. For example, indices tend to have fixed spreads, while currency pairs spreads fluctuate depending on the fluctuations in buy and sell prices.
The spread calculation involves subtracting the last significant digit of the buy price from the sell price. Consequently, the smaller the spread, the more favorable it is for the trader, offering a more economical way of making trades.
Spread indicators for traders are visually displayed on charts, explaining the direction of the spread relative to the buy and sell prices. More liquid pairs show narrower spreads, while exotic pairs tend to have wider spreads.
External factors, particularly market volatility, contribute to spread fluctuations. Notable events such as important economic announcements can cause a currency pair to strengthen or weaken, which will subsequently affect the spread.
Traders can prepare in advance for potential spread increases by monitoring economic calendars and staying on top of events that may affect the liquidity of currencies.
The spread in Forex trading is usually more modest for currency pairs with high trading volume, such as major dollar pairs. This is mainly because of increased liquidity. However, economic instability can still trigger spread widening, so be careful. During major trading sessions, particularly in London, New York and Sydney, spreads are often reduced.
The timing of overlapping sessions, such as the end of the London session and the beginning of the New York session, can cause spreads to narrow even further. In addition, spreads are significantly influenced by the general dynamics of supply and demand for currencies: increased demand leads to a simultaneous reduction in spreads.
Careful observation and analysis of these factors allows traders to make informed forecasts about possible spread changes, which enables them to adapt their strategies intelligently.