About to place your first forex trade? Let’s figure out how forex spreads work.
When trading forex, the price you will get for buying or selling is always slightly different, this difference is called the spread.
Highly liquid pairs like EURUSD will usually have very tight spreads, whilst less liquid pairs like USDZAR will generally have wider spreads.
Forex Spreads Explained
Competitive Spreads
If you’ve been busy trying to select a broker for your first forex trade, you’ve probably noticed a lot of advertising material and competition regarding forex spreads.
Though spreads in the forex market are incredibly tight and relatively small compared to less liquid markets like stocks, they are still a fee levied on your trading performance and there’s no sense paying any more in fees than you have to.
International banks, institutions and brokers all make forex markets, that is they are always ready to buy and sell a currency pair whatever the price. This kind of activity carries inherent risk in that if they are selling a currency pair that is steadily rising, they are steadily losing money as people buy that pair and it rises.
On the other hand, if their customers were on the wrong side of that trade, they would make money – a zero-sum game. This is why spreads exist, in order to make money consistently, whether the markets rise or fall and no matter what their customer base does, these market makers add a small markup to the rates they quote.
Think of spreads like the markup any retailer applies to their stock before selling it to you – without this mark up they would not be in business. Another perhaps more pertinent example is the edge a casino builds into their games of chance to stack the odds slightly in their favour on every spin – if half their clients lose and half their clients win, the house still ends up in front due to this edge.
This is exactly how market makers and brokerages generate consistent profits.
The Highest Bid and Lowest Ask
Forex spreads are determined by the highest bid and lowest ask for a given currency pair.
The highest price any participant is willing to buy a currency pair for is known as the bid, the lowest price any participant is willing to sell the same currency pair for is known as the ask and the difference between the two is the spread.
Example:
Highest EURUSD Bid = 1.2199
Lowest EURUSD Ask = 1.2201
EURUSD Spread = 0.0002
When you buy a currency pair at market, you pay the ask price.
On the other hand, when you sell a currency pair at market, you pay the bid price.
Confusing? This is just like shopping for a new car and finding the dealer with the lowest asking price, or selling that car used a few years later to the highest bidder.
When buying, you pay the ask, when selling you receive the bid.
Spreads in forex are generally expressed in pips, though as the market has become more competitive, lots of broker’s spreads are now just fractions of a pip so you may see them expressed in points – there are 10 points to a pip.
In the above example, we have a 2 pip or 20 point spread.
Forex Spreads Add Up Over Time
Although a 2 pip fee on a trade doesn’t seem like much when most forex pairs move 50 pips or more a day, when you are paying this fee on every trade and making hundreds of trades per year, this really does add up after a while.
Spreads are also an immediate barrier to profit, as soon as you open a trade, you will need to overcome the spread before your trade can be closed at breakeven or profit. As such, if you are trading a scalping strategy that seeks to capitalise on lots and lots of small market movements, spreads become extremely important.
Liquidity Determines Spreads
As spreads are determined by the highest bid and lowest ask, the more participants buying and selling a given currency pair, the tighter the spreads will be.
As the EURUSD is the most actively traded pair in the world, spreads are generally very tight and some brokers may even loss-lead on this pair as a drawcard.
On the other hand, a pair like USDZAR has a much lower global trading volume than EURUSD and spreads are generally much wider.
Even so, exotic pairs with wider spreads are often known to make much larger and more sustained moves which more than compensate for wider spreads.
Spreads also fluctuate throughout the day depending on the time of day and currency pair. For example, the ZAR is more liquid during South African business hours and the New-Zealand and Australian Dollars will have tighter spreads during their respective business hours.
Irrespective of the currency pair, spreads are generally much wider between the hours of 5 pm and 6 pm NY – so you should pay close attention and be especially careful if getting into the market at this time.
Calculating Forex Spread Costs
Calculating forex spread cost is easy, you just need to know two things:
- The value of a pip
- The spread in pips
By multiplying the two of these together, you will be able to calculate how much spread you will pay on any given trade.
This is very straightforward on currency pairs that are quoted in USD, as the value of a pip on a 1.00 lot trade is always $10 USD.
Example:
If you purchase one lot of EURUSD with a 2 pip spread, you will pay $20 USD in spread.
2 pips x $10 pip value = $20
Calculating the pip cost for a pair with a USD base is as simple as dividing the standard $10 pip value by the current exchange rate.
That is if USDCAD is trading at 1.10, you would divide $10 by 1.10 to get the pip value in USD = $9.09.
Example:
If you purchase one lot of USDCAD at 1.10 with a 2 pip spread, you will be paying $18.18 USD in spread.
2 pips x $9.09 pip value = $18.18
Are You Paying Too Much?
Whether you’re a scalper, day trader or long-term trader, forex spreads matter and add up over the course of your trading career.
Blackstone Futures is your trusted local South African forex broker and we have some of the lowest spreads in Africa.
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