Forex Trading is the exchange of currency pairs, where the value of one currency’s exchange rate gets pitted against that of another currency. The exchange rate at which a customer agrees to buy a quote currency is the Bid while the quote currency’s selling price is the Ask. The difference between the Bid price and the Ask or offer price is what is known as the Spread. It is a representation of the variance between the maximum price a buyer wills to purchase the securities at, and the lowest price that the seller is willing to sell the FX instruments. Commonly, the FX Spread is denoted in PIPs or Percentage In Points. The Spread is a crucial factor to investors as it is a hidden cost which they incur when trading in bonds, securities, futures, foreign currency or even futures.
Factors that influences the Spread in FX trading?
Supply or Float: If the total number of outstanding shares available for trading are many, then the Spread tends to be lower and vice versa.
Currency Liquidity: Popular currency pairs often have a lower Spread compared to the rare and precious currency pairs.
Demand for the securities: The higher the demand or interest in a particular FX stock, the higher its Spread is likely to rise, more so where the demand outweighs the supply.
The volatility of the market: In high volatility, the Spread is often wider in comparison to quieter market conditions, due to the associated risks.
The amount of trading activity: Premium or Large scale customers enjoy a lower Spread, due to discounts and economies of scale.
Competition: The desire for Forex Companies and Brokers to attract investors can also result with the Spread price being at the lowest levels possible.
Types of Spread
Fixed Spread: The Spread in which the difference between the Ask and Bid price remains constant and is not affected by the prevailing or anticipated market conditions. They are a common feature of automatically traded accounts.
Fixed Spread with an Extension: It is the type of Spread in which one of its parts gets predetermined by another part of the Spread. The FX dealer might adjust that part of the Spread depending on the prevailing or anticipated market conditions.
Variable Spread: Here, the Spread shifts depending on the existing market conditions, where it lowers during inactivity up to an average of 1 to 2 PIPs and raises or widens during volatile market activity. During the volatile times, the Spread can extend up to 40 to 50 PIPs.
How to calculate the Spread in the forex market?
Trading involves the base currency and the counter currency pairs. For example in the expression USD/CAD, the USD is the base currency while the CAD is the counter currency. If it takes C$1.31 to purchase US$1, it is denoted as 1.31/1 or 1.3.
In such a case, if the USD/CAD Bid price and Ask price is is 120 and 120.5 respectively, then the Spread will be the Ask price minus the Bid price to give 0.05, or $0.0005.