It’s important to be familiar with forex spreads as they’re the primary cost of trading currencies. In this lesson, we’ll explore how they work, as well as how to calculate costs and keep an eye on changes in the spread to maximize your trading success.

What is a spread in forex trading?

Every market has a spread, and so does forex. This is simply defined as the difference between the buy and sell price of an underlying asset. If you’re familiar with equities, you may synonymously call this the bid/ask spread.

Let’s use this example of a deal ticket showing EUR/USD to explain how spreads are calculated.

As you can see, the buy price is 0.97105 and the sell price, 0.97099. If you subtract the sell price from the buy price, you’ll get 0.00006.

Next, you can identify the pip value. Pips are often identified as the fourth digit after the decimal, however, since the spread in this example is less than 0.0001, the spread is actually identified in the fifth digit and is thus a fraction of a pip. The final spread in this example is therefore 0.6 pips.

Now that you know how to calculate the spread in pips, let’s look at the actual cost incurred when you trade.

How to calculate the forex spread and costs

Using the quotes from our example above, we know we can currently buy EUR/USD at 0.97105 and close the transaction at a sell price of 0.97099 (provided you do so before the market moves). That means as soon as your trade is open, you’d incur a cost equivalent to 0.6 pips (the spread).

To find the total spread cost, you’ll then need to multiply this value by the pip cost while considering the total amount of lots traded.

For instance, if you traded a EUR/USD mini-lot (10,000 units), you’d incur a spread cost of:

0.00006 (or 0.6pips) x 10,000 = $0.6

Similarly, if you traded a standard lot (or 100,000 units of currency), your spread cost would be 0.00006pips (or 0.6pips) x 100,000 (1 standard lot) = $6.

Remember, you may also need to pay other fees as required by your broker – such as commission.

If the base currency on your trading account is different to the base currency of the pair you’re trading, like GBP, you’d have to convert your money to USD. This will also incur a conversion fee.

Understanding a high spread and a low spread

FX spreads can vary over the course of the day, ranging between a ‘high spread’ and a ‘low spread’. This is because the spread can be influenced by multiple factors, like volatility or liquidity.

Liquidity simply refers to how active a market is – ie, how many people are buying and selling the share, currency pair or any other market. On the other hand, volatility describes how drastically a market’s value changes over time.

You’ll notice that some forex markets, like emerging market currency pairs, have a greater spread than major currency pairs.

This is because major pairs trade in higher volumes compared to emerging market currencies; and higher trade volumes tend to lead to lower spreads under normal conditions.

Here’s a quick exercise:

A market’s liquidity can directly influence its volatility. High liquidity (or more people trading on a market) usually translates to low volatility as multiple participants ‘balance out’ each other’s trades.

On the other hand, low liquidity (or less people trading on a market) can cause dramatic changes in a market’s price (or high volatility).

High spread

A high spread means there’s a large difference between the bid and ask price. As mentioned, emerging market currency pairs (eg USD/CNH) generally have high spreads compared to major currency pairs (eg GBP/USD).

A higher-than-normal spread generally indicates one of two things: high volatility in the market or low liquidity due to out-of-hours trading.

Low spread

A low spread means there’s a small difference between the bid and the ask price. It’s preferable to trade when spreads are low, like during major forex sessions. A low spread generally indicates that volatility is low, and liquidity is high.

Keeping an eye on changes in the spread

Major news events are notoriously known to cause market uncertainty. Releases on the economic calendar happen sporadically. And depending on whether expectations are met or not, these events can cause prices to fluctuate rapidly.

Not even large liquidity providers know the outcome of a news event on a market’s movements prior to its release. Because of this, they look to offset some of their risk by widening spreads.

Spreads can cause margin calls

If you’re currently holding a position, and the spread widens dramatically, you may be stopped out of your position or receive a margin call.

A margin call is an alert sent to a trader to tell them that they no longer have enough capital in their account to keep their position(s) open. When this happens, they’ll need to either close their position(s) or add more funds to the account.

The only way to protect yourself during times of widening spreads is to limit the amount of leverage used in your account. If the option is available to you, it’s also beneficial to hold on to your trade until the spread has narrowed before exiting a trade.

In the next lesson, we’ll look at some strategies you can adopt to successfully navigate forex spreads.