How Do Forex Spreads Work?

If you're new to the world of forex trading, you may have come across the term "forex spreads" and wondered what it means. How exactly do forex spreads work and why are they important in the forex market?

When trading forex, currencies are priced in pairs, with a buy price and a sell price. The difference between these two prices is known as the spread.

Understanding how forex spreads work is crucial for anyone looking to trade currencies effectively. The spread not only affects the cost of your trades but also directly impacts your potential profits. In this article, Benzinga explains the concept of forex spreads, how they are calculated, and why they matter in the forex trading world. Whether you're a beginner or a seasoned trader, having a clear understanding of spreads can significantly enhance your trading strategies.

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What is Spread in Forex?

Although forex is essentially a ratio between 2 currencies, it doesn’t have 1 single price for buying and selling.

When you observe the forex quotes, you might notice a difference between the bid (the price you can sell) and the ask (the price at which you can buy). This difference is spread, and it is the way for brokers and other trade processing intermediaries to make money. They do this by selling the currency for more than they paid for it — or buying it from you for less than they will receive when they sell it.

The spread is measured in percentage-in-point (pip) — the currency pair’s smallest unit of price movement.

The cost that you incur in the base currency will depend on the size of your trade and the width of the spread. For example, if you traded EUR/USD at a size of 1 lot (100,000 units, or $10 per pip) at the time when the spread was 2 pips, it would cost you $20 to enter the trade.

Yet, this sum would not deduce from your balance immediately — you will simply enter the trade being $20 in the red.

How do Investors Cover a Forex Spread?

Simply said, the only sure way for investors to cover the spread is to trade profitably. Spread is the unavoidable cost of trading, but few tips can help you manage it.

1. Find the Best Setups

Be as close as possible to being wrong before entering the trade. If you can improve the risk-to-reward ratio in your trades, you can trade at a smaller size and still make good money. The spread you pay is proportional to the size you’re trading at.

2. Trade the Most Liquid Pairs

If your trading strategy is not tied to a specific currency pair, you should prefer the most liquid pairs as they’re the cheapest. For example, you might only pay 1 pip spread to enter a GBP/USD trade, while it might cost 4 pips to enter a GBP/CAD trade.

3. Implement the Spread in Your Trade Planning

Remember to count the spread in the equation if you’re moving your stop-loss or take profit levels after you get in profit.

When do Forex Spreads Change?

Forex spreads change based on the underlying supply and demand and risk factors for market makers.

In the everyday market, this would mean an increase in spreads during periods with less activity and a decrease during periods of high activity. You can see how the overlap between the London and New York sessions has the highest volume and, thus, the lowest spread.

Forex market volume through the day, Source: Forex.com

Yet, this is not without exemptions as there are 2 examples when spreads can widen, even at that time.

• High volatility: This is usually driven by a news event that causes extreme volatility spikes, like interest rate decisions, employment news or GDP projections. Spreads usually dramatically widen as market makers have to manage the risks of processing trades.
• Low volatility: Bank holidays are a great example of low volatility, even at usual peak times. Spreads can widen on those days because of diminished volume.

How do Forex Traders Secure Low Spreads?

Securing low spreads is something every forex trader is looking to do. Here are the best ways to secure low forex spreads.

Use a Good Broker

Depending on the location, you will have some brokers as options. Yet, not all brokers are equal. There are 3 ways in which brokers process the trades: straight-through-processing (STP), electronic communication network (ECN) and market-making (MM). The first 2 are a type where your trade gets matched with another, opposite trade; the last one is kept “in house” and traded against you.

Although some traders find the fact that some brokers offer fixed spreads, they do not exist. They’re virtually guaranteed by market makers who take the other side of the trade.

Thus, you should stick with the regulated STP or ECN brokers who send your orders to the real market for a small commission and offer realistic spreads.

Pick the Right Time to Trade

Spreads fluctuate depending on the liquidity. At the start of the day, in the Australian session, they can be multiple times higher than a daily average. Meanwhile, in the London/New York session overlap, they can be almost nonexistent.

Reduce the Number of Trades

Although trading less will have no impact on the spread you get, it will drastically reduce the spread you pay. After all, the spread is the cost. Yet, avoiding overtrading has an additional benefit as it will prevent the mistakes that might throw you off the trading plan. 

Use Expert Advisor to Track the Spreads

It can be hard to follow the spreads, especially if you are watching many currency pairs. Expert advisor (EA) might be a worthy addition to your toolbox to help you stay on top of spread fluctuations. Additionally, it might help to decide to pick a better opportunity when faced with a choice between the highly correlated currency pairs. (Hint: Look for ones with a smaller spread but the larger average true range (ATR).

Get a Cashback Deal

A spread is an inevitable cost you’ll pay. However, if you are looking to trade through an STP/ECN broker and paying a commission, you might find a cashback deal from a 3^rd party. These rebates are a portion of the transaction cost payback to you on each trade. This results in a lower net spread and thus a lower cost of trading. 

An Unavoidable Cost

“Even when you don’t pay the taxes, you still pay the spread.” 

This old market proverb is applicable regardless of your local taxation. Spread is simply the cost of doing the business. Yet, like any other cost, it can be managed.

By using the guidelines from this article, you’ll be able to improve profitability. Reducing the cost of trading is an underrated way to higher profits. 

Secure Low Spreads with These Top Forex Brokers

Every trader needs a good broker, especially when it comes to finding the best spreads. In the table below, you will find a comparison list for the forex brokers that Benzinga recommends.

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