What Is a Forex Spread and How to Calculate It?
Learn the fundamentals of forex spreads, including their calculation and the market factors that influence these key trading costs.
A forex spread represents the cost of trading in the foreign exchange market, serving as the primary fee. It is the difference between the price at which a currency can be bought and the price at which it can be sold. This difference is how brokers generate revenue for facilitating currency transactions. The spread is an inherent component of every currency trade, built directly into the quoted prices.
Understanding Bid and Ask Prices
When trading currencies, two prices are always presented: the bid price and the ask price. The bid price is the rate at which a broker is willing to buy the base currency, or the price at which you can sell it. Conversely, the ask price, also known as the offer price, is the rate at which a broker is willing to sell the base currency to you, meaning it is the price at which you can buy.
The ask price is consistently higher than the bid price. This difference between the buy and sell rates creates the spread, which serves as the broker’s compensation for the immediate execution of a trade. For instance, if you wish to sell euros for U.S. dollars, you would do so at the bid price, but if you want to buy euros with U.S. dollars, you would pay the higher ask price.
Calculating the Spread
The spread is typically measured in “pips,” which are the smallest unit of price movement for a currency pair. For most currency pairs, one pip is equivalent to 0.0001, representing the fourth decimal place. For currency pairs involving the Japanese Yen (JPY), a pip is usually 0.01, or the second decimal place.
To calculate the spread, one simply subtracts the bid price from the ask price. For example, if the EUR/USD currency pair is quoted with an ask price of 1.1027 and a bid price of 1.1025, the spread is 0.0002. This difference translates to a 2-pip spread. In another instance, if USD/JPY is quoted at an ask price of 145.55 and a bid price of 145.50, the spread is 0.05, which equals a 5-pip spread.
Factors Affecting Spreads
Several factors influence the width of forex spreads, causing them to widen or narrow. Market liquidity plays a significant role; currency pairs with high liquidity, such as major pairs, generally exhibit tighter spreads because there are many buyers and sellers, leading to competitive pricing. Conversely, less liquid pairs, like exotic or minor currencies, tend to have wider spreads due to lower trading volume.
Market volatility also impacts spreads, with periods of high volatility often leading to wider spreads. Major economic news announcements or geopolitical events can cause sharp price movements, prompting brokers to widen spreads to manage their risk. Additionally, the time of day can affect spreads; during peak trading sessions when major financial centers overlap (like London and New York), spreads are often tighter due to increased trading activity.
Types of Spreads
Forex brokers typically offer two main types of spreads: fixed spreads and variable spreads. Fixed spreads, as their name suggests, remain constant regardless of market conditions. These are often offered by market makers, providing predictability in trading costs. However, during periods of extreme market volatility, fixed spread brokers might implement “requotes,” where they offer a new price if the original cannot be honored.
Variable spreads, also known as floating spreads, fluctuate continuously based on market supply and demand. These spreads can be very tight during calm market conditions and periods of high liquidity. However, variable spreads can widen significantly during important news events or times of low liquidity. Brokers operating on an Electronic Communication Network (ECN) or Straight Through Processing (STP) model commonly offer variable spreads, directly reflecting real-time market prices.