Notifications Bell

Lesson 10: Spread

Lesson 10: Spread

The spread is one of the key costs involved in financial trading. Generally, the tighter the spread, the better value you get as a trader.

The word ‘spread’ has a variety of definitions in other areas of finance, but the fundamental concept of being a difference between two prices is always evident. A spread in trading is an example of this, where the purchase of one asset and sale of another occurs simultaneously.

What is a spread?

The spread is the gap between the highest price someone wants to buy at and the lowest price someone is willing to sell at and needs to be factored into the explicit commission charged for executing the trade.

Where there is an efficient market - such as forex - with a lot of people both wanting to buy and sell in equal amounts, that gap will be very small.

It is an implied cost because you only feel the effect in subsequent trades, as the asset you bought must increase above the level of the Spread, rather than the price you bought at, for you to make a profit.

The spread is one of the key costs involved in online trading. Generally, the tighter the spread, the better value you get as a trader. We offer consistently competitive spreads, starting from just 1 pip for EUR/USD and USD/JPY currency pairs and from 1.0 points for the US30 and 0.4 points for the USA500 indices.

Visit our markets page for more information about our spreads.

How does spread in trading work?

The spread is a crucial piece of information to be aware of when analyzing trading costs. An instrument’s spread is a variable number that directly affects the value of the trade.

Spreads are constructed around the current price or market price of an asset. Market makers and brokers may add some transactional costs in the spread to simplify the transaction process, which can be particularly prevalent in futures contracts.

Several factors influence the spread in trading, as follows:

  • Liquidity. This refers to how easily an asset can be bought or sold. As the liquidity of an asset increases, the bid-ask spread usually tightens
  • Volume. This is a method of reporting the quantity of an asset that is traded daily. Assets that have a higher trading volume will often have narrower bid-offer spreads
  • Volatility. This is a measure of how much the market price changes in a given period. During periods of high volatility, when prices change rapidly, the spread is usually much wider

What is the Spread in Forex?

The spread in forex is a small cost built into the buy (bid) and sell (ask) price of every currency pair trade. When you look at the price that’s quoted for a currency pair, you will see there is a difference between the buy and sell prices – this is the spread or the bid/ask spread.

Changes in the spread are measured by small price movements called pips – which is any change in the fourth decimal place of a currency pair (or second decimal place when trading pairs quoted in JPY). It is not only the spread that will determine the total cost of your trade, but also the lot size.

spread in trading
Remember, every forex trade involves buying one currency pair and selling another. The currency on the left is called the base currency, and the one on the right is called the quote currency. When trading FX, the bid price is the cost of buying the base currency, while the ask price is the cost of selling it.

With us, you can trade forex using derivatives, 24 hours a day. Derivative products enable you to take a position on forex without taking ownership of the underlying asset. You can go long or short, which means you can speculate on rising as well as falling currency prices. And you only need a small deposit – called margin – to open your position.

The margin on a forex trade is usually only 3.33% of the value of the trade, which means you can make your capital go further while still getting exposure to the full value of the trade. Note, while margin can magnify your profits, it will also amplify any losses.

How to calculate the spread

Our WebTrader calculates the spread automatically, so you do not have to, but it is still useful to know where our spread costs come from.

To calculate the spread in forex, you have to work out the difference between the buy and the sell price in pips. You do this by subtracting the bid price from the ask price. For example, if you’re trading GBP/USD at 1.3089/1.3091, the spread is calculated as 1.3091 – 1.3089, which is 0.0002 (2 pips).

forex spread

Spreads can either be wide (high) or tight (low) – the more pips derived from the above calculation, the wider the spread. Traders often favor tighter spreads, because it means the trade is more affordable.

If a market is very volatile, and not very liquid, spreads will likely be wide, and vice versa. For example, major currency pairs such as EUR/USD will have a tighter spread than an emerging market currency pair such as USD/TRY. However, spreads can change, depending on the factors explained next.

Why does the spread change in forex?

The spread in forex changes when the difference between the buy and sell price of a currency pair changes. This is called a variable spread – the opposite of a fixed spread. When trading forex, you will always deal with a variable spread.

The forex spread may increase if there is an important news announcement or an event that causes higher market volatility. One of the downsides of a variable spread is that, if the spread widens dramatically, your positions could be closed, or you’ll be put on a margin call. Keep an eye on the economic calendar to stay abreast of upcoming financial events.

Know your spread

It’s very important to know the spread in the financial markets. The spread is the cost of each transaction that the broker charges and determines if that cost is appropriate for your trading strategies.

Secondly, all investors and traders should be educated about the lack of information regarding the possibility of manipulating the spreads on their trading platforms without the consent of their clients. On certain occasions, there are unscrupulous brokers who exercise this practice to obtain more profits. Therefore, t’s essential that the trader choose a reliable forex broker with a good reputation and that is not guilty of any spread manipulation. It is also advisable to trade with a highly regulated company since the regulators require companies to meet strict requirements regarding the financial products and services such as the safety of clients’ funds in segregated accounts.

Even if you work with brokers that do not engage in any tampering, let’s go back to the importance of the spread as it represents the cost to the trader. A trader that trades with low spreads will have less operating cost and long-term savings. Therefore, a high spread trader will have to generate higher profits to offset the cost. For many traders, the spread is very important within their losses and gains. For example, if a trader makes many short-term trades (scalping or day trading) a high spread can result in absorbing most of their profits. For a long-term trader in which each trade generates a certain amount of pips in profit, the spread is a matter of little relevance since it has little impact on the results of the trading.

How to Manage and Minimize the Spread

You have two ways of minimizing the cost of these spreads:

  1. Trade only during the most favorable trading hours, when many buyers and sellers are in the market. As the number of buyers and sellers for a given instrument increases, competition and demand for the business increase, and market makers often narrow their spreads to capture it.
  2. Avoid buying or selling thinly traded assets. Multiple market makers compete for business when you trade popular instruments, such as the major currency pairs, blue-chip stocks, global stock indices, and top cryptocurrencies. If you trade a thinly traded instrument, there may be only a few market makers to accept the trade. Reflecting the lessened competition; they will maintain a wider spread.

Final Words

Trading spreads are implemented by market makers, brokers, and other providers to add costs to a trading opportunity, based on supply and demand. Depending on how expensive, volatile, and liquid an asset is, the spread will fluctuate along with an asset's price and trading volume.

  • A spread is the cost of a trade, built into the buy and sell price of an asset
  • In forex, the spread is measured in pips, which is a movement at the fourth decimal place in a forex pair’s quote (or second place if quoted in JPY)
  • To calculate the spread, subtract the buy price from the sell price
  • Spreads are always variable, whereas other markets’ spreads may be fixed
  • Spreads can either be wide (high) or tight (low)
  • Traders often favor tighter spreads, because it means the trade is more affordable
  • If a market is very volatile and not very liquid, wide spreads may occur
  • If a market has high liquidity but is not very volatile, tighter spreads may occur
  • Factors like important news announcements or an event that causes higher market volatility can cause spreads to change

FAQ

What is the bid-ask spread?

The bid-ask spread is the difference between the bid (buy) price and ask (sell) price for a financial instrument. Live buy and sell prices are displayed on the trading platform, and change depending on several factors including market sentiment and liquidity in the market.

What does a wide spread indicate?

A wide spread indicates that there is a large difference between the bid and ask price of an instrument. This could potentially signal that the market is more volatile than usual, or there is low liquidity. A wider spread usually comes with a higher level of risk, so you should consider the risk-management before opening a position.

Is it better to trade a narrower or wider spread?

In general, a narrower spread is seen as less risky to trade. For example, forex traders often look for major currency pairs with a tighter spread of around 0.7 or 0.9 pips, as this generally represents lower market volatility and higher liquidity.

What is a spread cost?

A spread cost simply represents the transaction cost for an instrument. Instead of charging a separate trading fee for when traders place an order, the cost is instead built into the buy and sell price.

How do you calculate the spread in trading?

To calculate the spread of a financial instrument, you subtract the bid (buy) price from the ask (sell) price. You don’t need to calculate the spread manually when opening a position; instead, our platform does this automatically.

The information presented herein is prepared by ae.capex.com and does not intend to constitute Investment Advice. The information herein is provided as a general marketing communication for information purposes only.

Users/readers should not rely solely on the information presented herewith and should do their own research/analysis by also reading the actual underlying research. The content herewith is generic and does not take into consideration individual personal circumstances, investment experience or current financial situation.

Key Way Markets Ltd shall not accept any responsibility for any losses of traders due to the use and the content of the information presented herein. Past performance and forecasts are not reliable indicators of future results.
Share this article