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What is the Spread and How it is Determined

by on January 13, 2014 12:53 am GMT
 

The spread in forex is comprised of a bid and ask, and being able to understand how spreads are calculated are greatly important because it is the cost of entering and exiting the market.

The bid is the price the the trader is willing to purchase the currency pair at, while the ask is what the trader is willing to sell the currency pair for. The spread is the difference between the bid and ask which represents the cost entering the market.

At this point is it also important to understand how particular pairs are quoted. Yen pairs are quoted two decimal places. Other major pairs, such as the EURUSD, GBPUSD or EURGBP, are quoted at five decimal place. However, some brokerages may only quote up to four decimal places, but the calculation is the same. Different platforms have various ways of displaying the spread, but it does not have any affect and is more cosmetic then anything.

This shows the USDJPY quote with two decimal points and the B (bid) and A (ask). The spread is calculated by subtracting the two. In this case, the spread would be three pips:

Chart of USDJPY Showing the Bid/Ask Spread and Quote.

Chart of USDJPY Showing the Bid/Ask Spread and Quote.

The EURUSD is quoted in four decimal places, but the spread is calculated to the fifth decimal. The spread at this given time is two pips:

Chart of EURUSD Showing the Bid/Ask Spread and Quote.

Chart of EURUSD Showing the Bid/Ask Spread and Quote.

The overall spread is important because it determines the cost to enter both a long or short trade, and it is only “charged” to the trader once the trade is executed. The total cost depends on the position size the trader initially enters in at. For instance, a 10K position, or a .10 lot, represents $1 per pip. This is how much gained or lost per pip increment, so the brokerage takes this and multiplies it by the spread. The USDJPY example would cost $3, and EURUSD would cost $2 to enter the trade. The trade would then start off with a negative $3 or $2 balance once the trade is first executed.

The spread for major pairs that offer liquidity are usually small, and minor and exotic currency pairs can have rather wide spreads which costs the trader more to trade that pair. For example, the current spread (as of 1/12/14 at 7:32PM EST) for EURTRY is 42 pips. So, the trader, on a 10K position, would open with a balance of negative $42. The spread for major pairs could widen, too, during non-liquid trading hours and/or events with expected high volatility.

Spreads are important because trading is a business, and spreads should be taken as a business expense. They are the cost of doing business and cannot be avoided. A trader must know when a trade is worth taking on a larger spread.

The EURTRY is volatile, and a trader could make a lot of pips if the trade goes in their favor. However, the spread could greatly hurt the trader’s balance if it does not. If the stop-loss is 50 pips per trade, the total lost on a EURUSD trade would be 52 pips, or $52. The loss on EURTRY would be 92 pips, or $92. That’s a $40 difference.

Also, a trader wouldn’t scalp wide spreads because they start deeper in the whole. Be sure to know what the spread of your favorite currency pairs are, and it would be prudent to mark down in a journal or notebook times when the spreads widen. You then could further determine whether or not to trade during these time frames.