In order to understand the Forex spread you must understand how currencies are quoted. As soon as you open any Forex trading platform you will notice that currencies are quoted in two prices: the bid, which is the price you buy a currency pair and the ask price, which is the price you sell a currency pair. The difference between the bid price and the ask price is known as the spread.
The bid is the highest price that someone is willing to pay for a currency pair while the ask is the lowest price that someone is willing to sell it for.
The spread is simply viewed as the primary cost of doing business in the Forex market and usually replaces the commissions or any other forms of transactions fees that you might have to pay to your broker.
Types of Spreads
There are two different types of spreads charged by your broker. The most common spread is the Fixed Spread which means that the difference between the bid price and the ask price is kept constant. The second type of spread is the Variable Spread which means that the difference between the bid and the ask price fluctuates in accordance with market conditions.
What does a Spread Tell You?
The spread is primarily a function of currency liquidity and in this regard, a lower spread will tell you that the Forex pair liquidity is greater, while a higher spread will tell you that the Forex pair liquidity is low. The major currency pairs which have the biggest trading volume are usually traded with the lowest spreads while exotic currency pairs are traded with higher spreads. A wider spread will make it more difficult to profit from the trade; that’s why it’s advised to only trade lower spreads currency pairs.
Dependent on the type of the spread you’re charged, your Forex broker can either be a Dealing Desk broker or a Non-Dealing Desk Broker, so the spread also gives you more information about your Forex broker.
Spreads During News Events
Before major economic announcements or news releases, the market volatility can increase considerably. These events can cause large price movements either up or down, so spreads may widen due to uncertainty and risk. Usually, during news events, market participants are pulling off their bids and offers which means lower liquidity is available and that causes the spread to widen.
The great thing about news trading is that you can generally predict when these news events are likely to occur, even if you can’t necessarily predict in which direction the market is going to move it. Just knowing when the market is likely to move because of a news event, is still very helpful and extremely important for gauging when the spread is likely to widen.
Spreads Can Cause Margin Calls
If we trade Forex currency pairs with variable spreads and the spread suddenly widens up, there is a risk of causing a margin call. A margin call is the process of liquidating all open positions in order to ensure you’re not losing more than your account balance. As we already learned that spreads usually widen up during news events and if you’re overleveraged, than the risks of getting a margin call increase considerably.
The reason we have a spread is so that there’s no arbitrage in the market; which means that there’s free money. You can’t just go out and buy a Forex pair and immediately sell it right back to the market without having any risk whatsoever. The wider the spread is, the greater the Forex volatility and the more vigilant you should be with your trading. Successful trading requires to focus on the spread management which should be part of your risk management. More on this topic can be found here: Risk Management in Forex Trading.