Today we talk about the understanding of foreign exchange spreads.
The forex market is one of the most volatile markets globally, where even issues like the Omicron variant entering a country for the first time could affect the currency exchange rate. For many traders, a good way to interpret if a trade is good is to calculate the spread of two currencies.
The forex spread is the difference between a forex trader or broker’s sell rate and buy rate when trading a pair of currencies. In this article, we will tackle how the spread affects the forex market and how traders can calculate it to create a strategy.
Factors that Affect ‘Spread’
Spread is also the gain or loss on the transaction, making it essential to learn to prevent spread manipulation. The manipulation is when the platform control spreads to get more profit without the consent of the traders.
To prevent manipulation and misinformation in trades, traders must learn what affects the spread. Keep yourself updated on economic and geopolitical events that drive it to widen or narrow down.
For instance, if the unemployment rate in the U.S. turns out higher than expected, the dollar would most likely weaken or lose value against most currencies. These events make it difficult for a broker to determine the actual exchange rate, leading them to charge a wider spread for a trade to ease the risks of loss.
The time of day can also have critical effects on the spread. For instance, European trading opens during the early hours in the U.S. and the late hours in Asia. If you book a euro trade in while in Asia, the spread will be wider and more costly than trading during European hours.
Simply put, trading a currency during hours outside its ordinary time zone will not have many traders involved, causing a lack of liquidity. If the market is not liquid, it makes the currency difficult to buy and sell. Brokers would again widen their spread to ease the risk if they could not get out of the position.
Remember that it will have a big difference between the two currencies with a wider spread, marking low liquidity and high volatility. Meanwhile, narrow spreads show low volatility and high liquidity, leading to smaller spread costs.
How to Calculate ‘Spread’
Now that you know the factors that could cause the spread to widen or narrow down, it is crucial to learn how to calculate it. First, you need to find out how currencies are quoted.
They always quote currencies in pairs, with the first one being the base currency and the second being the counter or quote currency. Thus, the quotation formula will quote currency/base currency. For instance, with U.S. dollars (USD) and Canadian dollars (CAD), it takes 1.25 CAD to buy 1USD, which will show as 1.25/1 and thus, the quote is 1.25.
Now, since we know how to find the quote of the currencies, you need to determine the bid, which is the price a broker will buy or sell the base currency in exchange for the quote currency. For instance, a U.S. trader plans to buy euros and the bid is $1.12/1.125. The trader will be charged the asking price of $1.125 to book the trade.
If the trader immediately sold the euros to the broker, they would get the bid price of $1.12 per euro, which would cost the investor about $0.005 based on the exchange rate’s bid-ask spread with the broker.
How to Use Spread in Trading Strategies
Since spread helps determine the gain or loss in trading, here are some ways you can adapt your trading strategy based on the spread of the currencies.
Using the Spread Indicator
A trading indicator can strengthen strategies based on the spread. The forex spread indicator displays a curve on the graph to show the direction of the spread related to bid and ask price. It visualizes the spread between the pair over time, with the most liquid pairs having tighter spreads and the rest having wider ones.
You can use the indicator to determine lower spreads in currencies traded in high volumes and avoid wider spreads that will lead you to costly losses.