New forex traders often find themselves taken aback when they realize that a trade they just entered is already showing a loss. They may begin to question whether their broker is attempting to deceive them. However, it is important to understand that this occurrence is not a result of any scam. Instead, it is due to a fundamental concept known as the forex spread.
In this article, we will delve into the meaning of the forex spread and its impact on trading outcomes.
What Is A Spread In Forex Trading?
To comprehend the forex spread, we must first understand that it represents the disparity between the ask price and the bid price. Essentially, when a trade is executed, the purchase transpires at a marginally higher price than the sale price.
Refer to the illustration below, where the ask price denotes the purchase value and the bid price corresponds to the selling value.
Calculating The Forex Spread
Referring to the example image provided, we can calculate the spread as follows: 1.1630 – 1.1625 = 5 pips.
The official exchange rate is established by the Central Bank, subject to daily revisions. However, when dealing with currency exchange, you will not be able to buy or sell at this exact rate. Instead, the selling price will be slightly higher than the Central Bank rate, while the buying price will be slightly lower.
This difference in prices is the reason why each trade immediately shows a loss after opening. You purchased at the Ask price (higher) and will sell at the Bid price (lower). The MT4 terminal takes this into account, automatically displaying a small loss in the “profit” column equivalent to the size of the spread. Just as banks profit from exchange operations, brokers also generate their profit through the spread.
Hence, it becomes apparent that the broker earns from the spread on every buy or sell transaction, irrespective of whether it resulted in a profit or loss for the trader. Therefore, there is no incentive for the broker to engage in deceitful practices as they already earn from the spread.
Factors Influencing Forex Spread
The spread is influenced by several key factors that determine its magnitude. These factors include:
Liquidity: In the case of major currency pairs, the spread typically remains narrow, consisting of just a few points. However, for exotic instruments with lower trading volumes, the spread tends to widen. For instance, on a pair like GBPNZD, the spread might be as wide as 10 points, which is five times larger than that of EUR/USD.
Market Conditions: The spread can be affected by the prevailing market situation. Prior to the release of macroeconomic data or important speeches by regulatory officials, brokers often widen the spread. This is done to account for the increased volatility and uncertainty during such events.
Trading Sessions: The spread is generally at its narrowest during the European and American trading sessions. This is because these sessions typically exhibit higher trading activity and increased liquidity, resulting in tighter spreads.
It is important for traders to consider these factors and monitor the spread dynamics as they can significantly impact trading costs and profitability.
Why Is The Spread Size Not Visible In MT4?
In MT4 (MetaTrader 4), by default, only the Bid price is displayed in the terminal settings, while the Ask price remains hidden. However, rectifying this is a simple process if you are using MetaTrader 4. Just right-click on the chart, navigate to “Properties,” and under the “Common” tab, check the “Show Ask Line” option. As a result, you will see two lines on the chart: the upper line representing the Ask price and the lower line representing the Bid sell price. You can also use that custom MT4 Spread Indicator.
Various Types Of Forex Spreads
Forex brokers offer different types of spreads to cater to the needs and preferences of traders. The main types of spreads include:
Fixed Spread
Under this type, the spread remains unchanged regardless of market conditions. It is particularly popular among forex brokers, especially for novice traders. The spread size remains constant at all times, such as 3 pips. This allows beginner traders to know in advance the commission they will pay before opening a trade. Additionally, fixed spreads enable accurate backtesting of forex trading strategies using historical data. However, a significant drawback is that the spread size can be relatively large.
Fixed Spread with Expandable Range
In this case, brokers have the flexibility to widen the spread. This practice is often implemented to discourage traders who tend to place pending orders, especially before the release of important economic data or on Fridays before the market closes. It acts as a safeguard against traders attempting to exploit market gaps by leaving orders open over the weekend.
Floating Spread
Typically associated with ECN (Electronic Communication Network) accounts, this spread type reflects the dynamic nature of the interbank market. The difference between the buying and selling prices fluctuates over time, potentially remaining minimal during periods of low volatility and widening significantly during news releases. In the long run, trading with a floating spread can be more profitable than a fixed spread.
Floating Spread with Commission
Similar to the floating spread described above, this type incorporates a minimum value or fixed commission below which the spread cannot decrease. Essentially, it combines the benefits of a dynamic spread with the assurance of a minimum commission.
Some account types offer zero spreads, with brokers earning profits solely from commissions. These commissions are relatively small and comparable to the spread itself.
It is crucial for traders to understand the characteristics of different spread types and choose the one that aligns with their trading strategies and objectives.
Managing And Minimizing Spread
To minimize the impact of spreads on your trading costs, consider the following approaches:
Optimal Trading Hours
Trade during the most favorable trading hours when the market is bustling with numerous buyers and sellers. When there is a higher number of participants in a specific currency pair, competition intensifies, leading market makers to narrow their spreads to attract more business. By trading during these active periods, you can take advantage of tighter spreads.
Avoid Thinly Traded Currencies
Steer clear of trading thinly traded currency pairs. When you trade popular currencies like the GBP/USD pair, multiple market makers compete for business. This heightened competition often results in narrower spreads. However, when dealing with thinly traded currency pairs, there may be only a few market makers available to accept trades. With reduced competition, these market makers tend to maintain wider spreads to compensate for the limited liquidity.
By focusing on trading during optimal hours and avoiding thinly traded currencies, you can effectively manage and minimize the impact of spreads on your trading expenses.
Conclusion
The spread serves as the broker’s compensation, and it entails a small fee charged on every transaction made by clients, even those that result in losses. Therefore, it is not unusual to observe a negative balance immediately after opening a position. It is important to understand that this is not a fraudulent scheme orchestrated by the forex broker; rather, it is simply the manifestation of the spread’s influence. As novice traders, it is essential to familiarize yourselves with key concepts such as forex spread, swap, margin levels, leverage, and more. This knowledge will empower you to navigate the intricacies of trading effectively.
