What Are Spreads in Forex and How Do They Work?

The foreign exchange (forex) market operates on the continuous exchange of currencies, where the “spread” plays a central role. A spread represents the cost embedded within every currency transaction, essentially how brokers generate revenue without charging explicit commissions. It is the difference between two prices for a currency pair, reflecting the immediate expense a trader incurs when opening a position. Understanding this cost is foundational for anyone engaging in forex trading, as it directly influences trade profitability.

Understanding Bid and Ask Prices

In forex trading, every currency pair is quoted with two distinct prices: a bid price and an ask price. The bid price is the rate at which a broker is willing to buy the base currency from a trader, representing the highest price a buyer is prepared to pay. The ask price is the rate at which a broker is willing to sell the base currency to a trader, indicating the lowest price a seller will accept. The spread is the difference between the ask price and the bid price, constituting the primary transaction cost in forex.

For example, if the EUR/USD currency pair is quoted at a bid price of 1.1000 and an ask price of 1.1002, the spread is 0.0002. This difference is commonly measured in “pips.” A pip is the smallest unit of price movement for a currency pair, typically defined as the fourth decimal place (0.0001) for most pairs. For currency pairs involving the Japanese Yen (JPY), a pip is usually the second decimal place (0.01).

Fixed Versus Variable Spreads

Forex brokers offer two main types of spreads: fixed and variable. Fixed spreads remain constant regardless of market conditions, providing predictability in trading costs. These are often offered by brokers operating under a market maker model, where they control the prices displayed to clients. While offering cost certainty, fixed spreads might include a premium for market risks. During high volatility, fixed spread brokers may face execution challenges, potentially leading to “requotes” (a new price offer) or “slippage” (execution at a different price than intended).

Variable spreads fluctuate continuously based on real-time market supply, demand, and liquidity. Brokers employing an Electronic Communication Network (ECN) or Straight Through Processing (STP) model often provide variable spreads, passing on prices from multiple liquidity providers. Variable spreads tend to be narrower during high liquidity and low volatility, potentially offering lower transaction costs. However, they can widen significantly during major news events or heightened market turbulence, increasing trading costs unexpectedly.

What Influences Spreads

Several factors contribute to the widening or narrowing of forex spreads. Market liquidity, which refers to the ease with which an asset can be bought or sold without affecting its price, significantly impacts spreads. Higher liquidity, characterized by a large number of buyers and sellers, results in tighter spreads. Conversely, periods of low liquidity, such as overnight trading sessions or major holidays, can lead to wider spreads due to fewer market participants.

Market volatility, indicating the degree of price fluctuations, also plays a substantial role. During times of high volatility, when prices are moving rapidly, spreads tend to widen as brokers adjust to mitigate increased risk. Major news events, including economic data releases like interest rate decisions or inflation reports, often trigger sharp increases in volatility. These events can cause spreads to expand considerably as market uncertainty rises and liquidity temporarily decreases.

The popularity of a currency pair is another influencing factor. Major currency pairs, such as EUR/USD or GBP/USD, exhibit tighter spreads due to their high trading volumes and greater liquidity. Exotic or less frequently traded currency pairs, by comparison, often have wider spreads because of lower demand and participation. Finally, the broker’s business model, whether they act as a market maker or an ECN/STP provider, influences the spreads they offer to their clients.

How Spreads Affect Your Trading

The spread is a direct trading cost that impacts a trader’s profitability. Each time a trade is initiated, it begins in a negative position by the amount of the spread. This means the price must move in the trader’s favor by at least the size of the spread before reaching a break-even point. This initial cost is particularly relevant for short-term trading strategies, such as scalping, which aim to profit from small price movements. Wider spreads can significantly reduce potential profits for these strategies, making it harder to achieve desired returns.

Widening spreads can affect the execution of pending orders, such as stop-loss and take-profit orders. During high volatility when spreads expand, a stop-loss order might be triggered at a less favorable price than anticipated, a phenomenon known as slippage. A take-profit order might not be executed at the exact target price if the spread widens. Understanding how spreads work and the factors that influence them is an important aspect of choosing a forex broker. Competitive spreads contribute to lower trading costs and improved long-term profitability for traders.