What Is Spread in Forex and How Does It Work?

The foreign exchange market, or forex, is a global marketplace for exchanging national currencies. Participants buy and sell currencies to profit from exchange rate fluctuations. A small but consistent difference exists between the buying and selling prices. This difference is known as the spread, representing a built-in cost of engaging in the market.

Defining the Forex Spread

The forex spread represents the difference between two quoted prices for a currency pair: the bid price and the ask price. The bid price is the rate at which a broker is willing to buy the base currency from a trader. Conversely, the ask price is the rate at which the broker is willing to sell the base currency to a trader. From a trader’s perspective, one sells a currency pair at the bid price and buys it at the ask price. This means that to immediately close a trade after opening it, a trader would incur a loss equal to the spread, as they would buy at the higher ask price and sell at the lower bid price.

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, or the fourth decimal place in the quote. However, currency pairs involving the Japanese Yen (JPY) are an exception, where a pip is measured at the second decimal place, or 0.01. For example, if the EUR/USD pair is quoted with a bid price of 1.1051 and an ask price of 1.1053, the spread is calculated by subtracting the bid from the ask (1.1053 – 1.1051 = 0.0002). This results in a spread of 2 pips. This spread acts as the transaction cost, serving as a primary source of revenue for brokers.

Factors Influencing Spread

Forex spreads fluctuate based on market conditions. Market liquidity significantly influences the size of the spread. Currency pairs that are highly traded and have substantial trading volumes, such as major pairs like EUR/USD, have tighter spreads due to the ease with which they can be bought and sold. Conversely, less liquid currency pairs or “exotic” pairs, which are traded less frequently, often have wider spreads because there are fewer buyers and sellers, making it more challenging to match orders.

Market volatility also influences spread width. During periods of high volatility, such as major economic news releases or unexpected geopolitical events, spreads tend to widen. This widening occurs as market uncertainty increases, leading brokers to adjust their pricing to mitigate risk. For instance, announcements regarding interest rate decisions, Gross Domestic Product (GDP) figures, or employment data can cause sudden and temporary spikes in volatility, directly impacting spreads.

The time of day and specific market sessions also affect spread sizes. Spreads are generally tighter during peak trading hours when major financial centers, like London and New York, overlap, as this is when market liquidity is at its highest. During off-peak hours, such as overnight sessions or weekends, liquidity decreases, often leading to wider spreads. Understanding these market dynamics helps traders anticipate changes in transaction costs.

Impact of Spread on Trading

The spread represents the transaction cost a trader pays to their broker. Every new position starts at a negative value equal to the spread. The market price must move beyond the spread to reach the break-even point before profit. This inherent cost impacts overall profitability, particularly for short-term trading strategies.

To understand the monetary value, consider the lot size and pip value. For currency pairs where the U.S. Dollar is the quote currency (e.g., EUR/USD), a standard lot of 100,000 units means each pip movement is approximately $10. A mini lot of 10,000 units equates to about $1 per pip, and a micro lot of 1,000 units translates to roughly $0.10 per pip. For example, if a trader opens a standard lot trade on EUR/USD with a 2-pip spread, the initial cost of that spread would be $20 (2 pips x $10/pip).

Wider spreads increase trading costs, reducing potential profits, especially for strategies like scalping that aim for small, frequent gains. A wider spread demands a larger price movement in the trader’s favor before the position becomes profitable, making it harder to achieve desired returns. Conversely, tighter spreads are more favorable for traders because they minimize transaction costs, allowing positions to move into profit more quickly with smaller price movements. Understanding how spreads are calculated and influenced is crucial for managing trading expenses and setting realistic profit targets.