The bid-ask spread is one of the most important concepts for forex traders to understand. It represents the difference between the price at which you can buy and sell a currency pair at any given time. While it may seem insignificant, the bid-ask spread can have a major impact on your trading performance and profitability.
This comprehensive guide will explain everything you need to know about the bid-ask spread, including what it is, how it works, factors that widen or tighten spreads, and strategies to manage the bid-ask spread in your trading. With a strong understanding of bid-ask spreads, you can make better trading decisions and improve your bottom line.
What is the Bid-Ask Spread?
The bid-ask spread is the difference between the bid price and the ask price for a currency pair. The bid price represents how much you can sell the base currency for, while the ask price is how much you need to pay to buy it.
For example, if the bid price for EUR/USD is 1.1200 and the ask price is 1.1205, the spread would be 0.0005 or 5 pips. This means sellers are willing to sell euros and buy US dollars at 1.1200, while buyers are willing to buy euros and sell dollars at 1.1205.
The bid and the ask prices are set by forex market makers and vary based on supply and demand. The spread exists to provide profit for the market maker who matches buyers and sellers to provide liquidity to the market. The wider the spread, the more profit the market maker earns from each trade.
Why Does the Bid-Ask Spread Matter?
While a 5 pip spread may seem small, it adds up significantly over time and a large number of trades. Every time you open and close a position, you pay the spread twice – once on entry and once on exit.
For example, if you traded 100,000 EUR/USD and the spread was 5 pips, you would pay $50 to enter and $50 to exit, for a total cost of $100. Scale that up to millions of dollars in trading volume and the costs become quite high.
The bid-ask spread is essentially a trading fee, so you want to minimize the spread you pay on each trade. Paying lower spreads results in higher profitability over time. Traders should aim to deal with brokers and currency pairs that offer tight spreads.
How is the Bid-Ask Spread Formed?
There are several factors that influence how wide or tight the bid-ask spread is at any given time:
1. Liquidity
The most liquid currency pairs like EUR/USD and USD/JPY have tight spreads because they have the largest number of buyers and sellers constantly quoted prices. Less liquid pairs have wider spreads to compensate for the lower volume.
2. Volatility
When volatility increases, the spreads widen because there is more uncertainty in the market. The market makers protect themselves from risky price swings by quoting wider spreads.
3. Trading Session
Spreads tend to be wider during illiquid trading sessions like weekends and holidays when trading volume dries up. The most liquid sessions like London and New York will have tighter spreads.
4. News/Events
Big news announcements and economic data releases cause volatility to rise temporarily, leading to wider spreads. Market makers protect themselves from volatility around major events.
5. Broker Costs
Brokers have operating costs they cover by retaining a portion of the spread. Brokers with higher costs will quote wider spreads to maintain profitability.
6. Competition
Competitive forex brokers are willing to sacrifice some profit by narrowing their spreads to attract more traders. Less competitive brokers retain wider spreads.
By understanding what impacts the bid-ask spread, you can make choices to minimize the spread costs in your trading. Trade during liquid sessions, use limit orders, and choose competitive brokers quoting tight spreads.
Average Bid-Ask Spreads for Major Currency Pairs
Here are the typical bid-ask spreads seen for some of the most commonly traded forex pairs:
- EUR/USD: 0.4 – 2 pips
- USD/JPY: 0.2 – 2 pips
- GBP/USD: 1 – 3 pips
- AUD/USD: 0.8 – 4 pips
- USD/CAD: 1 – 5 pips
- USD/CHF: 1 – 5 pips
- EUR/GBP: 1 – 3 pips
Exotic pairs like USD/ZAR or USD/SEK often have spreads of 50 pips or higher due to much lower liquidity. Minor pairs like GBP/JPY and EUR/AUD fall somewhere in between.
These numbers can fluctuate according to the factors discussed earlier. Use these averages as a guide, but expect actual spreads to vary frequently.
Dealing with Wider Spreads During News Events
One of the biggest frustrations for forex traders are the wide spreads that emerge around major news announcements and data releases. For major pairs like EUR/USD, spreads that are normally 2-3 pips wide can blow out to 10 pips or higher for a period of time around major announcements.
These wider spreads result from elevated volatility and uncertainty in the market. Market makers need to protect themselves from order imbalances by widening spreads. However, these temporary spread spikes can wreak havoc on your trading.
Here are some tips to deal with wider spreads around news events:
- Avoid market orders – use limit orders instead to specify your desired entry or exit price.
- Widen take profit and stop loss levels to account for spread increases.
- Avoid trading immediately before and after news – wait 10-15 minutes for spreads to normalize.
- Reduce position sizes to limit damage from wider spreads.
- Understand the spreads for exotic pairs will be persistently higher.
- Avoid illiquid trading sessions around news events.
While wider spreads are frustrating, they can be managed by changing your trading behavior. With proper preparation, you can still trade successfully despite short-term spread volatility.
How Brokers and Trading Platforms Impact Spreads
Not all forex brokers are equal when it comes to bid-ask spreads. Spreads can vary significantly from one forex broker to the next, even when trading the exact same currency pair. There are several factors that influence each broker’s specific spreads:
Liquidity Providers
Brokers connect to large banks and financial institutions to provide liquidity and execute trades. Brokers with better liquidity providers can access better spreads to pass on to clients.
Trading Volume
Higher overall trading volume allows brokers to negotiate tighter spreads from their liquidity providers. These savings get passed on to active traders.
Commission/Fees
Some brokers charge commissions and fees rather than wider spreads. Active traders may benefit from paying commissions in exchange for lower spreads.
Technology
More advanced trading platforms improve connectivity and execution, resulting in lower spreads. Older platforms have higher latency and spreads.
As a trader, you should evaluate a broker’s typical spreads when choosing a platform. Open demo accounts with various brokers to compare spreads on the currency pairs you trade. Favor brokers providing consistently tighter spreads on your pairs.
Strategies to Reduce the Bid-Ask Spread
Here are some tips and strategies traders can use to reduce the negative impact of bid-ask spreads on their trading:
1. Compare Brokers and Platforms
As mentioned, spreads vary significantly across brokers. Opening demo accounts is the best way to identify brokers with consistently tighter spreads. Advanced trading platforms also improve pricing.
2. Trade During Liquid Sessions
Concentrate your trading during peak volume sessions like London and New York when spreads are tightest due to high liquidity. Avoid illiquid sessions with lower volume.
3. Focus on Major Pairs
The major pairs like EUR/USD, GBP/USD and USD/JPY have the tightest spreads due to higher volume. Trade these over exotics and minors when possible.
4. Use Limit Orders
Limit orders allow you to specify the exact price you want to buy or sell at, avoiding any slippage on wider spreads. Use limits instead of market orders whenever possible.
5. Keep Positions Smaller
Smaller position sizes minimize the impact of the spread. Keeping trades modest allows higher frequency of trading without spread costs accumulating.
6. Avoid Scalping Strategies
Scalping strategies involve very short holding times and high frequency. This amplifies spread costs since you pay the spread frequently.
By applying these tips, you can significantly reduce the negative impact of spreads on your trading results. Monitor your overall spread costs and aim to minimize this overhead over time.
Final Thoughts on Managing Bid-Ask Spreads
The bid-ask spread represents a hidden but significant cost that forex traders need to minimize and manage. Wider spreads slowly eat away at your profits over time. By understanding the factors that impact spread widths, avoiding periods of elevated spreads, and using strategies to reduce your spread costs, you can boost the profitability on your trading.
Compare brokers and choose one offering consistently tight spreads on the currency pairs you trade. Focus on highly liquid major pairs, use limit orders, trade during peak volume sessions, and keep your position sizes reasonable. With good habits, the bid-ask spread does not need to be a major detriment to your trading success. Master the basics covered in this comprehensive guide and save significantly on spread costs over the long run.
