Forex trading can be an extremely profitable venture for traders who understand how to analyze the market, identify trading opportunities, and manage their risk/reward ratio. However, one aspect of forex trading that all traders need to be aware of is the spread – what it is, how it works, and how it affects your trading strategy and profitability. This complete guide will provide you with everything you need to know about forex spread to trade effectively.

What is Spread in Forex Trading?

The spread in forex trading refers to the difference between the bid price and the ask price of a currency pair. The bid price represents the maximum price that a buyer or trader is willing to pay for a currency pair. The ask price is the minimum price that a seller or dealer is willing to receive for that same currency pair.

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 spread is basically the transaction cost or commission when you open a forex trade. It is how forex brokers and market makers generate their revenue from trades.

Spreads will differ depending on the currency pair being traded as well as between forex brokers. More liquid currency pairs like EUR/USD will generally have tighter spreads than less liquid pairs. The spread is essentially the cost that the forex trader has to pay for each trade, so it represents a loss that must be overcome through price movement in the trader’s favor before they can generate a profit on the trade.

Types of Spread

There are two main types of spread in the forex market:

Fixed Spread

As the name suggests, a fixed spread remains constant and does not change. This spread is set by brokers and provides traders with greater certainty in terms of transaction costs. Although spreads are “fixed”, different currency pairs will have different fixed spread values.

Variable Spread

A variable spread fluctuates throughout the day in response to market conditions and liquidity. Also known as a floating spread, the spread values are derived from the interbank market and subject to frequent changes. Variable spreads tend to be lower than fixed spreads on average but less predictable.

Brokers may offer a mix of fixed spreads, variable spreads or give traders an option to choose between the two on their platforms. In general, variable spreads are better for short term traders while fixed spreads may appeal more to longer term investors.

What Impacts the Spread in Forex Trading?

There are several factors that influence the size and variability of spreads:

  • Liquidity – The greater the liquidity and trading volume for a currency pair, the tighter spreads tend to be. Major pairs like EUR/USD will have lower spreads than exotic pairs.
  • Volatility – During news events or periods of higher volatility, spreads tend to widen due to uncertainty and increased risk for market makers.
  • Trading Session – Spreads may widen outside of normal trading hours and sessions when liquidity is lower.
  • Broker – The spread values are ultimately set by the forex broker based on their own costs and desired profit margins. Comparing spreads between brokers is useful for finding the best rates.
  • Trader Type – Institutional and high volume traders may receive preferential spreads from brokers while smaller retail traders will face higher spreads.

Being aware of when spreads are likely to widen or shrink can help traders make adjustments to their strategies and improve trade execution.

How Spread Impacts Your Trading

The spread in forex has direct implications on your trading strategy, profitability, and overall costs:

  • Reduces Profit Potential – Every non-commission forex trade starts off with a loss equal to the spread, so profitability is immediately reduced. Wider spreads mean greater losses per trade.
  • Increases Need for Stop Loss – With every trade starting at a loss due to the spread, a larger stop loss is required to give trades room to move profitably.
  • Limits Use of Scalping – Scalping strategies involve opening and closing many small profit trades throughout the day. The spread makes scalping more difficult due to higher transaction costs.
  • Favors Longer Timeframes – Long term trades have more time to achieve larger price movements needed to overcome the spread and depreciation costs.
  • Impacts Position Size – Traders may trade lower position sizes per trade because the spread represents a higher relative cost when trading small lots.

Essentially, spread chips away at your trading profits. Having a solid understanding of spreads allows you to make adjustments and account for these costs in your overall trading plan.

How to Reduce the Impact of Spread

Here are some tips traders can use to reduce the negative impact of spread on their trading:

  • Trade With a True ECN Broker – True ECN brokers offer access to the real interbank spreads which are lower than regular broker spreads. This immediately reduces costs.
  • Use a Smaller Spread Markup – Compare fixed spread markups between brokers to find ones offering tighter spreads. Even fractions of a pip count over hundreds of trades.
  • Trade High Liquidity Pairs – Stick to the major and minor pairs which have the tightest spreads to reduce depreciation per trade.
  • Trade During Peak Volume Hours – Trading sessions overlap and volatility leads to wider spreads. Trading during peak hours like London-New York overlaps minimizes this.
  • Use Spread Indicators – Charts can display live spread values so traders can see when spreads are widening and wait for tighter spreads before entering trades.
  • Go Long Term – Longer term trading timeframes amortize the spread out over more pips of profit potential so the relative impact is lower per trade.
  • Use Stop Limit Orders – Stop limit orders can eliminate slippage spikes beyond spreads when volatility widens spreads at market open.

With the right broker, strategy, and effective use of spread analysis, traders can significantly reduce the impact of spread on their long term trading performance.

Final Thoughts on Understanding Spread

Although spreads represent a cost to traders, they are a necessity in forex markets and part of transaction costs in nearly every trading arena. By taking the time to learn what spreads are, how they work, and simple ways to reduce their impact, traders can account for spreads and continue profitable trading.

With the insights in this complete guide, you now have a solid foundation for evaluating spreads and incorporating them into your overall forex trading approach. Rather than viewing spread as a frustrating cost, knowledgeable traders view them as one of many variables to factor into a winning trading system.