On the Forex market, just like on any financial market, transaction costs are charged whenever you open a new position. In Forex, this transaction cost is called the “spread” and represents the difference between the Bid and Ask prices of a currency pair. However, to understand how Forex brokers derive their spreads and what Bid and Ask prices are, you first need to understand how currency pairs are quoted in Forex.
Introduction to Forex spreads
On the Forex market, currencies are always traded in pairs. A currency pair consists of the base currency (the left-hand side of the pair) and the counter, or quote currency (the right-hand side of the pair). The quote of a currency pair tells us how many units of the counter currency it is possible to buy with one unit of the base currency.
Let’s explain this further by looking at a typical example of a Forex pair.
The EUR/USD pair is trading at 1.1845. In this example, the euro (EUR) is referred to as the base currency, and the US dollar (USD) as the counter or quote currency. What this rate tells us is that the US dollar is trading at 1.1845 USD for 1 euro. Simply put, buying 1 euro will cost us 1.1845 USD.
To give another example, let’s take a look at the USD/JPY pair, which is trading at 108.50. Now, the US dollar is the base currency and the Japanese yen the counter or quote currency. If this pair is trading at 108.50, it simply means that 1 USD can buy 108.50 Japanese yen at the moment; or to put it another way, buying 1 USD will cost us 108.50 Japanese yen.
Forex traders try to anticipate the future price movements of currency pairs in order to make a profit. If a trader thinks that the rate will go up, they will buy the pair. And if they think the rate will fall, they will sell the pair. A rise in the currency rate means that the base currency is appreciating (rising in value), and the counter currency is depreciating (falling in value). If the EUR/USD pair from our example rose to 1.1890, we would have to pay a higher price in dollar terms for one euro (i.e. the euro buys more US dollars than before), which tells us that the euro has appreciated against the US dollar.
How currency spreads are calculated
Now that we know how currency pairs are quoted against each other, let’s move on to Forex spreads. There are always two rates available for a given currency pair; the Bid rate and the Ask rate. Depending on whether you’re buying or selling the base currency, you’ll have to pay a different rate. The Bid rate is the rate at which your broker is willing to buy the base currency from you, and the Ask rate is the rate at which they’re willing to sell the base currency to you.
The difference between the Bid and Ask rates is called the “spread”, and represents your broker’s profit. As in all markets, the broker tries to buy the base currency at a lower price (Bid rate), and sell it later for a higher price (Ask rate). That’s why the Ask rate is higher than the Bid rate.
Let’s take the EUR/USD pair from our first example again and expand it to include the Bid/Ask information. The following table expands on our previous example with the Bid and Ask prices for the EUR/USD pair.
The EUR/USD rate of 1.1845 represents the Bid rate, i.e. the price in dollar terms at which the broker is willing to buy 1 euro from you. The Ask rate of 1.1847 is the rate at which the broker is willing to sell 1 euro to you. This represents a spread of 2 pips. Whenever you open a position, you will eventually have to close the position at some time in the future, paying the spread to your broker.
The cost of the spread depends on the size of the position you intend to open. While the pip value of a 1k position size is approximately 0.1 USD, the pip value of a standard lot (100k) position is closer to 10 USD. Opening a 10k position on EUR/USD with a 1 USD pip value would incur a 2 USD spread cost on the transaction.
Still, Forex has one of the lowest transaction costs compared to all other major financial markets. The cost of opening a position (transaction cost) on the Forex market is usually only the spread that your broker charges, which can be as low as 1 pip on the most-traded majors, such as EUR/USD or GBP/USD. On the other hand, cross currencies that don’t involve the US dollar, such as GBP/JPY, as well as exotic and less liquid currencies, can have significantly larger spreads. That’s why traders need to take Forex spreads into account when building their trading strategy.
Types of Forex spreads
There are a number of different types of spreads that are used on the Forex market. The following types are the most common:
- Fixed spreads - These spreads are constant and don’t depend on market conditions.
- Fixed spreads with an extension - These spreads contain a fixed part, and a variable part which may be adjusted by the broker according to current market conditions.
- Variable spreads - Variable spreads fully represent the current market condition and the pair’s liquidity. Under normal market conditions, variable spreads can be very tight (as low as 1 pip on major pairs), but with increased market uncertainty and during major news releases, those spreads can go as high as 40 - 50 pips.
Factors that influence the spread in Forex trading
Forex spreads are variable and depend on various factors; including market liquidity, market conditions, upcoming economic data and investor sentiment. During times of important market reports, such as reports on economic growth, inflationary reports or interest rate changes, the spread usually widens. Simply said, whenever there is an imbalance of buyers and sellers for a specific currency pair, the spread will widen to reflect this market condition.
As a trader, you naturally want to minimise the cost of your transaction, and you can do this by following these few rules:
- Avoid trading exotic currency pairs. It’s better to stay with the majors. All majors have very tight spreads as brokers and market makers compete against each other to increase their market share. This is beneficial for traders as they will pay lower transaction costs with tighter spreads. On the other hand, less popular currency pairs with lower competition and liquidity will have significantly higher spreads.
- Trade only during the most active hours on the Forex market. As the number of market participants increases, spreads usually narrow as there are many buyers and sellers for any given price of a currency pair. The most active part of the day on the Forex market is the overlap of the New York and London sessions, between 12:00 PM and 4:00 PM GMT. This is also the time when the largest price fluctuations take place.
- Avoid trading during major news releases. The Forex market is full of excitement and there is a major news release for at least one of the eight major currencies nearly every day. Traders and large investors tend to stay away from the market until the release has been published, as this is usually accompanied with large price movements and an imbalance between buyers and sellers, which widens the spread.
- Gaps and wide spreads often come together. If there’s an important market event over the weekend, the price will tend to open with a gap lower or higher than the market closed on the previous Friday. When such a gap forms with the opening of the Sydney session, spreads are often very wide, and can reach dozens of pips even on major currency pairs such as EUR/USD. After the session and trading week gain momentum, the spread also narrows. As such you should avoid trading immediately after a gap forms if transaction costs are very important to your trading strategy.
This article explained why taking care with transaction costs on the Forex market is an important milestone to becoming a profitable trader. Knowing the best times when to trade the market, and how to avoid extremely high spreads, can make a significant difference in the bottom line for every trader. This is especially true for day traders or scalpers who tend to open many trades in a short period of time, where transaction costs incurred by spreads can represent a significant chunk of their profit. The most important note to remember is that during increased market uncertainty and major news releases, spreads can skyrocket even on major currency pairs. On the other hand, trading exotic currency pairs will always incur increased transaction costs compared to the majors, and you should avoid these pairs altogether unless you have a specific (and profitable) trading strategy for trading the minors.