FOREX SPREADS EXPLAINED AND WHAT AFFECTS THEM

What is a Forex Spread?

In the world of foreign exchange (Forex) trading, a spread is defined as the difference between the bid price and the ask price of a currency pair. The spread represents the transaction cost of executing a trade and is typically measured in pips (percentage in points).

The bid price is what the market is willing to pay for a currency pair. The ask price (or offer price) is the price at which the market will sell it to a trader. The difference between these two values is the spread.

Why Do Forex Spreads Matter?

Spreads are significant because they directly impact a trader’s profitability. A narrower spread means a lower cost of entry, while a wider spread implies higher transaction costs. Since Forex trades occur in high volumes and often feature tight margins, even a small spread difference can be significant over time.

Types of Forex Spreads

• Fixed Spreads: These remain constant regardless of market volatility. They are typically offered by dealing desk brokers.
• Variable or Floating Spreads: These fluctuate depending on market conditions. They are more common with non-dealing desk brokers, such as ECN (Electronic Communication Network) or STP (Straight Through Processing) brokers.

How Spreads Are Displayed

In most trading platforms such as MetaTrader 4 or 5, the spread isn’t shown as a separate figure but can be calculated by subtracting the bid from the ask price. Some platforms may also indicate the spread in points or pips in real-time.

Impact on Trading Strategy

Spreads affect different trading strategies in various ways. For example, scalpers—those who make multiple trades each day—prefer low spreads because they trade frequently and need low costs. Long-term traders might be less affected as the spread cost becomes marginal across extended holding periods.

Common Currency Pairs and Typical Spreads

Spreads vary depending on the liquidity and volatility of the currency pair:

• Major Pairs (e.g., EUR/USD, GBP/USD): Typically have lower spreads due to high liquidity.
• Minor or Cross Pairs (e.g., EUR/GBP, AUD/JPY): Tend to have moderate spreads.
• Exotic Pairs (e.g., USD/TRY, EUR/ZAR): Often feature high spreads due to low liquidity and higher risk.

Understanding what the spread is and how it affects your trading cost is a foundational concept every trader should master to make informed trading decisions.

What Causes Forex Spreads to Widen?

There are several reasons why Forex spreads widen, most of which are related to market conditions, trading volume, and macroeconomic influences. Widening spreads are common during volatile periods and may signal elevated trading risks.

1. Market Volatility

One of the most common causes of wider spreads is increased market volatility. This typically occurs during the release of major economic news, unexpected geopolitical events, or sudden changes in investor sentiment. Sudden price movements create uncertainty, prompting liquidity providers to increase spreads to manage risk.

2. Low Liquidity Periods

Liquidity refers to the ease with which a currency pair can be bought or sold without causing a large price movement. When trading volume is low—such as during off-market hours or holidays—spreads often widen due to a lack of counterparties. For instance, during the Asian trading session or just before a major economic announcement, spreads can expand significantly.

3. Currency Pair Characteristics

Not all currency pairs are created equal. Major pairs like EUR/USD have tighter spreads than exotic pairs like USD/TRY because they are more actively traded and feature higher liquidity. Wider spreads in exotic and minor pairs compensate for additional risk and reduced trading volume.

4. Broker Type and Business Model

• Market Makers: They often offer fixed spreads but may widen them during volatile times.
• ECN and STP Brokers: They provide variable spreads, especially susceptible to widening during news events or low liquidity.

The broker's execution model can influence how and when spreads change. Additionally, some brokers might enforce a minimum spread during certain conditions to protect their own exposure.

5. News Events and Economic Releases

Spreads frequently widen just before and after significant economic announcements, such as:

• US non-farm payrolls
• Central bank interest rate decisions
• Inflation and employment reports
• GDP data

During these events, price fluctuations become unpredictable, and brokers adjust spreads to hedge against adverse market movements.

6. Weekend Gaps and Market Openings

Market open on Sunday evenings (GMT) or post-weekend gaps often entails wider spreads. During these times, the lack of active market participants and limited liquidity contribute to less favourable trading conditions. Traders are advised to avoid initiating trades during these periods unless necessary.

7. Regulatory or Political Events

Events like Brexit announcements, trade sanctions, or political upheaval can induce dramatic changes in Forex spreads. In these scenarios, uncertainty and risk aversion lead liquidity providers to pull back or increase their spread quotes.

Risk Management During Widening Spreads

Traders should implement adequate risk management techniques to protect their capital. This involves:

• Using stop-loss and take-profit orders carefully.
• Avoiding trade execution during major news releases unless properly hedged.
• Monitoring the economic calendar to anticipate volatility.

Understanding the factors behind widening spreads empowers traders to avoid unfavourable conditions and preserve profitability.

How Traders Manage Spread Risk

Given that Forex spreads can fluctuate considerably, especially during unpredictable market conditions, successful traders adopt strategies to manage spread-related risks and minimise their impact on returns. Proper planning can help reduce exposure to unexpected trading costs and improve long-term outcomes.

1. Choose the Right Broker

Broker selection is the first step in managing spread risk. Consider the following criteria:

• Opt for brokers with consistently competitive spreads.
• Assess whether the broker offers fixed or variable spreads.
• Look for brokers regulated by reputable authorities such as the FCA, ASIC, or CySEC.

Brokers that aggregate quotes from multiple liquidity providers, such as ECN brokers, often offer tighter spreads, especially during stable trading hours. However, even top brokers experience spread widening in adverse conditions, so setting realistic expectations is essential.

2. Trade During Optimal Market Hours

Spreads are generally at their lowest during peak trading sessions when market liquidity is robust. This includes:

• London and New York sessions
• Major economic data release periods (with caution)

Avoiding trades during low-volume hours (such as between the US close and Asian open) can result in more favourable spreads and improved execution.

3. Avoid Trading Around News Releases

If not properly managed, high-impact news events can cause spreads to widen dramatically. Many experienced traders choose to avoid trading during such times unless market expectations are clear or they have hedged their risk accordingly.

4. Use ‘No-Dealing Desk’ Execution

Traders may prefer ECN or STP brokers that operate on a no-dealing desk model. These platforms offer direct market access and tend to charge raw spreads plus commission—often resulting in lower and more transparent costs overall, especially for frequent traders.

5. Monitor and Adapt Your Strategy

Traders should continuously evaluate market conditions and adjust their trading strategy based on observed spread dynamics. Scalpers, for instance, are highly sensitive to spread size and must remain vigilant when volatility increases.

6. Account for Spread in Profit Targets

When setting take-profit and stop-loss levels, it’s crucial to consider the spread. A wide spread can trigger a stop-loss prematurely or delay reaching the take-profit threshold. Calculating net gains after factoring in the costs due to spread is a prudent approach for accurate performance tracking.

7. Use Limit Orders Instead of Market Orders

Market orders are executed at the current available price, which might be unfavourable during periods of wide spreads. To mitigate unexpected executions, traders may instead use limit orders, which allow them to specify the exact price they wish to buy or sell at.

8. Implement Position Sizing and Leverage Controls

Risk exposure can be amplified through high leverage, particularly during times of volatile spreads. Using appropriate position sizing and leverage ratios can prevent disproportionate losses caused by spread fluctuations.

9. Track Spread History and Volatility Patterns

Many modern trading platforms offer historical spread charts and volatility indicators. By studying these metrics, traders can avoid high-risk timeframes and optimise trade entry and exit points.

In conclusion, understanding how spreads work and proactively managing related risks is essential for all Forex traders. By integrating spread-aware practices into their trading plans, traders can navigate market conditions more effectively and enhance their overall trading strategy.