What is the Importance of Spreads in Forex Trading?
So you think you know forex trading? If you don't know about spreads in forex trading, then you're missing one of the basic building blocks.
And that's putting you behind, because forex trading offers a lot of benefits to traders, including a 24/7 market, low transaction costs and high liquidity.
So what are spreads, and why do they matter in forex trading? Keep reading to find out.
The Basics
You have to learn to walk before you learn to run. Same story with forex trading. So let's cover a bit of groundwork first before we dive into spreads.
First, Let's Cover Your ABCs
First things first: The most basic premise of forex trading is that market investors are trading one currency for another. Like if we traded a certain amount of Euros for a certain amount of U.S. dollars.
To keep this trading information easy to follow, currencies are always quoted in pairs (for example: EUR/USD). It matters what order you put them in because the first currency is always the base currency and the second is the quote currency.
What does all that mean? Simple: If it took 3.5 Euros to buy 3 US dollars, then the expression EUR/USD, in this case, is equal to 3.5/3.
What are Spreads in Forex Trading?
Before we dive in and talk about spreads in forex trading, let's first talk about what a spread is.
A spread is the difference between the asking price and the bid price of an asset. Think of it like the string connecting two pins on a map - the distance between where you wanted to be and where you wound up.
Makes sense, since forex quotes are always given with a bid price and an asking price.
So what's the big fuss?
Calculating a Spread
Spreads are usually calculated in pips, or a percentage in point, the fourth decimal place in currency quotation.
Now, to the calculations.
So we know forex trading provides bid and ask quotes in pairs - the base currency and the counter currency.
The bid price represents the price the forex trader is willing to buy the base currency in exchange for the counter currency. Conversely, the asking price is the price the forex trader is willing to sell the base currency in exchange for the counter currency.
Essentially, think of the pairs as the price tag on the transaction - what you're willing to put in and what you'll get for it. In a perfect world (or a world where you're a smart forex trader) your spread will be small.
Fixed versus Variable Spread
Before you drive yourself nuts calculating, there are two types of spreads in forex trading that you need to be aware of.
Fixed - The difference between ask and bid is constant and does not depend on market conditions
Variable - Fluctuates in correlation with market conditions
When do you use them? Fixed spreads are used by companies for automatically traded accounts. Variable spreads are a more accurate representation of the market, but in volatile market conditions can vary ask widely as 40 or 50 pips, which makes market strategy much more difficult.
The Significance of the Spread
So what's the big deal about spreads?
We know spreads in forex trading are the difference between the bid price and the asking price. To put it simply, they're the cost of doing business - how much each individual trade is going to cost you.
Now, if you've got a small spread, say .0004 USD, it doesn't seem like that big of a deal at first. But if you're doing dozens and dozens of trades, suddenly that .0004 starts adding up to a significant number, especially because forex trades aren't dealing with small change - average traders work in the millions.
Oh, and the spread is affected by a variety of factors while you're trading. So not only are you dealing with large sums of money, your spreads will vary throughout the day, influencing your cost of trading and relative success.
What Influences a Spread?
Say your costs are varying - if you can control for those, you can manage your cost of trading and trade more successfully, right? How do you do that?
Well, that depends.
We mentioned fixed and variable spreads earlier. You'll see a lot of factors are work in modifying variable spreads, but one of the most important is currency liquidity. What the heck is currency liquidity?
The short version: Popular currencies are traded with low spreads whereas rare currency pairs raise your pips. Think of it sort of like basic supply and demand.
Another factor is the amount of the deal. We mentioned earlier that forex traders are typically dealing in significant sums. But sums that are extreme - too big or too small - are quoted with higher spreads because of the risk associated with the trade, whereas middle-of-the-road sums have less risk.
Remembering that variable spreads are also dependent on market conditions, you'll also realize that spreads are also dependent on market conditions. A volatile market has a higher risk, so the spread will be wider than a quiet market.
Think of it this way: The higher the risk, the wider the spread and thus the greater cost of the trade. This is why managing your spreads is so important.
Minimizing the Cost of Spreads
So how do you manage the cost of your spreads? There are two main ways to do this.
The first is to only trade during the most favorable trading hours - when more buyers and sellers are in the market to trade. If your instinct is that more competition is bad, you would be wrong - as the competition for a given currency pair rises, market makers will narrow their spreads to capture it.
This leads to the second point: Stick to trading popular currency pairs instead of rare ones. That's because higher competition for the pair will drive the spread down. Rare pairs have a higher risk because fewer people are trading.
Smarter Forex Trading
Trading doesn't have to be confusing.
