What is spread in Forex and how is it determined?

There is a very simple definition for spread in Forex assets as well as other financial instruments. It is basically the difference between buying and selling prices of the assets you are currently trading.
 
For example, let’s imagine a USD/JPY trade. In this pair’s case, we are buying JPY with USD, so we need to calculate accordingly. The market is requesting a price of 109.77 JPY per USD, so we buy. There’s another person trying to sell his USD and he is seeing a price of 109.79 JPY per USD. Once the trade goes through each trader gets the according amount and the spread comes in to be at 2 pips. So 109.79-109.77= 0.02.
 
But what is a spread in Forex trading? Why is there a gap between these prices? Well, it’s quite simple. The spread is usually an income source for the broker. Every broker has a “liquidity provider” who directs the trades to the market and helps both the broker and the trader make payouts.
Those liquidity providers have their own spread as well, so if the broker wants to have at least some income, they either have to charge commissions on the traders, or mark the spread up.

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Forex spread types - How many are there?

Although every spread type has one purpose of earning the broker some income they still come in different shapes and sizes. There are way too many to mention here, but the ones that are most important to know about are the following:
 
  • Bid/ask spread
  • Yield spread
  • Option adjusted spread
  • Negative spread
  • Z spread
 
However, we will still only talk about Bid/ask spreads, Yield spreads and negative spreads as the others are a bit more advanced.
 
Let’s get to know all of them one by one.


What is bid ask  spread

As already mentioned bid ask spreads are the most common ones to find with Forex brokers because they are such an easy way to get payouts for them.
 
The difference between the bid and the asking price is pretty much what you are paying the broker to receive their service. Although 1 pip may sound really small for making a good income for a company, remember that spreads are calculated according to the size of the lot you are trading.
 
For a standard lot, 1 pip would be equal to $10, for a mini lot it would be $1 and etc. The more you trade, the more the broker makes through spreads.

The perfect way to calculate how much you are spending on spreads is to use the following formula:
 
(ask-bid) x lot size = payment size.


Yield spread

Yield spreads are also pretty much the same as bid and ask spreads, but they are usually calculated for different assets. For example, the most popular asset that yield spreads are associated with bonds and here’s how they calculate them.
 
If there are two bonds of equal size and value, the difference between their yields will result in a yield spread.
So, if one bond has a yield of 10% and another has a yield of 5%, this would mean that the yield spread is only 5%.
 
This can be used for Forex as well. For example, a high yield spread would be something like this. Imagine that EUR/USD has a yield curve of 20%, and EUR/GBP has 5%. Both of these currency pairs are considered major ones, so calculating the yield spread on them is available.
 
The yield spread here would be 15%, indicating that more people will start transferring to the EUR/USD pair to find more payouts.


Negative spreads

Negative spreads are only negative for the brokers themselves. Basically what a negative spread means is that you can trade without having to “pay” the broker anything from your trade orders.
 
In fact, the broker guarantees that you immediately get a payout if the spread is negative. But this is possible only when you make the correct call. If the currency pair starts falling, then no amount of negative spread will be there to save you.
 
The negative spread Forex usually happens with high-interest rate currencies. The broker is able to profit so much from the government for holding or trading their currency, that they are ready to pay their customers to use this currency pair as much as possible.


Fixed and floating spreads

This is not necessarily a “type” of spread for Forex trading simply because every single spread can be either fixed or floating. They’re like the types of the types of Forex spreads.

A fixed spread is when the broker guarantees that no matter what happens in the market, the spread will remain the same. So, if the spread on EUR/USD was 1 pip, it will stay that way no matter what.
 
A floating spread is based on market demand. Similar to the price and exchange rate of the currencies, the spread can change by growing or lowering. The market then adjusts it based on how many people continue to trade that currency pair.


Spreads vs Commission

The spread in Forex is considered one of the best options for both brokers and traders, but it doesn’t mean that there is no alternative method for it. That alternative method is the commission. It’s usually very different depending on the broker you are trading with, but it doesn’t mean spreads and commissions can’t be compared.
 
The main factor is probably the guarantee of spreads and the unpredictability of commissions. You see, when the spread is fixed, you as a trader are already aware of how much you will pay for the broker’s services. But when you are on commissions, they could change dramatically. For example, your trade can grow overnight making you pay a commission, it could reach a deadline making you pay a commission or you could accidentally close the trade too early and again pay a commission.
 
The logic is quite clear, bid ask spreads may be slightly more expensive when we first look at them, but in the long run, commissions are much more likely of costing you more.


How can spreads change?

Fixed spreads change very rarely, but floating ones are guaranteed to do so. The most common case when a spread change is when there’s a shift in the market.
Imagine a news piece where the government of the United States says that they are increasing interest rates significantly. It’s likely for Forex brokers to react to this news and lower the spreads on their USD currency pairs.
 
Why? Because they want to increase their volume of USD trades so that the interest rate bonuses are applied to them.
 
Other reasons for changing the definition of what is a good spread in Forex include market trends and recessions. If the market decides that a specific currency pair is a lot more important to trade, it’s likely for a Forex broker to increase the spreads on it. Why? Because since a lot of people are trading it, it might as well increase their income due to the demand. This corrects the market and people diversify into different currency pairs eventually.
 
And in terms of recessions, Forex brokers could simply choose one major currency pair and offer the best spreads possible on it.

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Forex spreads - Key takeaways

A spread, no matter what we call it, is the difference between buying and selling prices of currency pairs or other assets. The higher the spread, the less income a trader can expect from their trading activities.
 
Spreads are the most popular way for Forex brokers to generate income. Most of them have fixed spreads which guarantees them a steady income. The higher the spread, the more income the Forex broker makes.
 
The best spread on Forex pairs can be found with major currencies. Things such as USD, EUR, GBP, JPY and etc. As long as the pair is constructed with these pairs the spread is almost guaranteed to be extremely low.
This is even more relevant for EUR/USD, which is the most traded pair in the market.
 
There are two types of spreads. A fixed one and a floating one. The floating spread changes all the time based on market movements and trends. The fixed spread could change on very rare occasions such as monetary policy changes or recessions.

FAQ on Forex spreads

Can I have better spreads than other traders?
Show answer
Yes. Some traders that have a much larger account would usually get better deals on their spreads.
 
For example, if the regular account has a spread of 3 pips on EUR/USD, a higher level account would have 1 pip spread. This is an advantage for the broker because they keep the high-level trader. What is spread in Forex but a way to generate income for the brokers?
 
It’s very hard to reach a high level account status though as it needs lots of trading volume. So whoever has that better spread condition definitely earned it.
 
How to calculate spread in Forex with pips?
Show answer
There’s such a thing called a pip spread definition in Forex. It’s usually different depending on the service provider you are using as it’s up to them to decide how to price their pips. But let’s consider that a standard lot pip is worth $10.
 
If you spread it to 2 pips, this means that you will have to pay $20 per 1 standard lot trader. A mini lot would cost $2, a micro lot would be $0.2 and a nano lot would be $0.02.
 
Is floating spread better than fixed?
Show answer
Not necessarily. They both have their advantages and disadvantages. For example, the fixed spread gives a guarantee that you will be charged only 1 pip per lot no matter what. A floating spread could possibly charge you 1.2 pips per lot or 0.8 pips per lot depending on how the market is performing.
 
There’s a risk factor with floating spreads, but it has a chance of being a bit more profitable for the trader. In most cases though, traders choose to go with fixed spreads so that they don’t have to do too much calculating.
 
Why would spreads be negative?
Show answer
Forex brokers don’t necessarily have their own storage of funds. They use things called liquidity providers. These liquidity providers are the ones that let you trade currencies and give you the funds for your leverage.
 
In case of a negative spread Forex pair, the liquidity provider is most likely trying to somehow acquire new retail clients or simply increase its volume for a quota. Forex brokers are often trying to not show you any negative spread options because it’s not profitable for them.
 

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