How to Understand Forex Spread

To understand forex spreads and how they affect you, you need to understand the general structure of any forex trade. The transaction structure can be viewed as all trades being executed through brokers who charge fees for their services.

Definition of the Difference Between Bid and Ask

The forex spread represents two prices: the buy price (ask) for a specific currency pair and the sell price (bid). Traders pay a certain price to buy the currency and are forced to sell it at a lower price if they want to sell immediately.

Forex Spread Determined by Market Makers

The forex market differs from the New York Stock Exchange, where trading historically took place in a physical location. The forex market has always been virtual and operates more like a wholesale market for small stocks, with trades facilitated by specialists known as “market makers.”

Sample Calculation

Every forex trade involves a currency pair called a currency pair. This example uses the British Pound (GBP) and the US Dollar (USD) – or the GBP/USD currency pair. Let’s assume that the British Pound equals 1.1532 times the US Dollar at a certain time.

Cost of the Spread

Using the above example, a GBP spread of 0.0004 does not seem significant, but even a small spread accumulates quickly when the trade is larger. Forex currency trades typically involve larger amounts of money.

How to Manage and Reduce the Spread

You have two ways to lower the cost of these spreads:

1. Trade only during the most favorable trading times, when there are many buyers and sellers in the market. As the number of buyers and sellers for a specific currency pair increases, competition and demand for the business rises, and market makers often lower their spreads to take advantage of this.
2. Avoid buying or selling currencies that are thinly traded. Many market makers compete for business when popular currencies, such as the GBP/USD currency pair, are being traded. If you’re trading a thinly traded currency pair, there may only be a few market makers willing to accept the trade. Due to the low competition, they will maintain a higher spread.

Frequently Asked Questions

What is a good spread in the forex market?

You can monitor the most liquid currency pairs to get an idea of what a good spread is in the forex market. USD/JPY and USD/GBP are two popular pairs in the forex market. You can compare the spreads of these two pairs with other currency pairs. Additionally, comparing spreads between brokers may help ensure you’re getting the best deal.

What does a high spread mean in the forex market?

A high spread indicates that the currency pair is less liquid than other currency pairs. In other words, fewer traders and dollars are focused on that pair. The fewer traders concentrating on a currency pair, the less likely it is that someone will be willing to provide a price closer to the opposite side of the trade. When trading occurs less frequently, the spread widens. Brokers may also include trading fees in the spread, even if they market themselves as a “commission-free” trading platform.

Source: https://www.thebalancemoney.com/what-is-a-forex-spread-1344973