In the world of currency trading, a couple of decimal points can make a big difference. Whereas some traders might be happy to take on the risk associated with the smallest possible price increments, larger numbers of buyers and sellers won’t.
For example, if you were selling something for £10 and someone offered to buy it at £9.90, you’d be unlikely to accept – even though you’ve just made a 10% profit – simply because it’s so difficult to shift your product at that price. This is because there’s no such thing as a “standard” price in currency markets: every trader has an idea of what constitutes an attractive offer or an acceptable bid. And this is where spreads come into play.
In essence, spreads are the difference between the bid and offer prices of a currency pair.
What Are Forex Spreads?
In simple terms, forex spreads represent the gap between the price at which you buy or sell. You buy at what is called “the ask” (or offer), while selling is called taking “the bid”.
If you’re buying EUR/USD at 1.0850, for example, this means that you’re paying 55 pip more than the market consensus on where the value of one Euro will be in relation to one US dollar by close of play today (1st March). If you were selling, it would mean getting 55 pips less for your Euros than everybody else has agreed they’ll pay for them (in this case buying at 1.0800).
Slippage is a term that describes the difference between where you actually end up trading and where you initially intended to trade – in terms of price, not time. In other words, if your position opened as planned but then moved against you as market activity increases (commonly referred to as “volatility“), slippage will be the resulting loss compared with what your chart indicated should have been a profitable entry.
Forex spreads are dynamic by nature, constantly changing according to current supply and demand levels, short-term events, and expectations for future performance. They can widen significantly during the hours of low liquidity early in the morning London time (when New York traders are getting ready for work) and after major news announcements, for instance.
Forex spreads can be fixed or variable, depending on the instrument used (for example, currency pairs are always variable while some stock indices may be fixed). Generally speaking, though, they’re expressed as either “bid”/”ask” or “mid”.
The bid is the price at which the market is prepared to buy; the ask, then, is where it’s willing to sell. The difference between these is called the spread. Alternatively, forex spreads can also be quoted in terms of mid-market level: this is simply an average of all bids and offers made by market makers operating within a particular currency pair at any given time. This number constantly changes, too, but the overall picture is a good deal more accurate as it’s based on live deals.
How Do You Calculate Forex Spreads?
For a currency quote, you’d typically calculate a spread by taking the difference between the bid and ask price of a given currency pair at any given time. For instance, if EUR/USD is quoted at 1.0875-1.0900, the calculations would be as follows:
EUR/USD bid : 1.0900 – EUR/USD offer: 1.0875 = Spread: 25 points x 10 = 250 pips
As a rule of thumb, a spread’s value corresponds with the number of pips you’ll get if you sell or buy one unit of a particular currency pair at that price level. Thus, in this instance, buying 100,000 units would cost £250 more than selling it – and any stop-loss orders you place to exit the trade will be executed at this price too.
What Affects Forex Spreads?
It might seem easy to calculate spreads, but even these figures can change from broker to broker because different companies have different ways of quantifying them. As well as the exact types of fees they charge (fixed vs variable, etc.), spreads can also fluctuate according to other factors like:
- Time of day
- Currency pair
- External economic reports
- Trading activity
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