Forex trading involves many aspects that must be analysed if you want to be successful. The market is constantly fluctuating, which is where forex spreads come into play. There are numerous factors that might alter spreads, making the buying and selling market complex to navigate. We’ll be looking at the factors that influence spreads below.
What Are Spreads?
When trading in the forex market, forex spreads are the difference between the bid and ask price for two currencies. The seller will set up a quote and sell the two currencies at the asking price. Foreign exchange spread refers to money supply and demand; the ask price represents supply, while the bid price represents demand.
How the Market Calculates Forex Spreads
To calculate forex spreads, brokers take the difference between the bid and ask price.
Forex Spread = Ask Price – Bid Price
Forex uses a unit of measurement called pip, percentage in point or the price interest point. This is the smallest unit in forex, meaning it can indicate the smallest movements in currency pairs.
The vast majority of currency pairs are quoted to four decimal places for the smallest unit, 0.0001. Let’s say you’re trading the EUR/USD currency pair, and the current rate is 1.2500. Should the exchange rate increase to 1.2501, that represents a single pip. The same applies if the exchange rate moves down.
4 Factors That Influence Forex Spreads
#1: Supply and Demand
Given their high demand, major currency pairs like EUR/USD and GBP/USD will have tighter spreads. Less popular currency pairs (minors and exotics) will have wider spreads because fewer market participants lead to a decrease in both supply and demand and lower trading volume.
#2: Liquidity
In short, liquidity relates to the rate at which currencies trade with minimal market volatility. When the market is very fluid, and both buyers and sellers are trading aggressively, expansion is usually tight. There’s a higher level of transactions happening, which means trades happen at competitive prices. If liquidity is low, i.e., in low trading times or less popular currency pairs, spreads will widen.
#3: Market Volatility
Forex spreads will often widen during high market volatility. This happens because an increased volatility leads to bigger price movements, so brokers must adjust their spreads according to these increases. Brokers also use these times to assess their risks and costs, reflecting the current market conditions.
#4: Fixed or Variable
There are different pricing models that brokers will offer, with the two key ones being fixed or variable.
In fixed spread, the spread remains the same regardless of how the market is behaving. This can be positive as they remain consistent, but you may find you could be paying a wider amount further down the line.
Variable spreads will fluctuate based on market conditions, giving you lower costs during high liquidity, but they may widen during market volatility.
Conclusion
Buying and selling spreads are dependent on a variety of factors, but having an understanding of what factors may influence forex spread changes is essential in setting you up for a successful forex venture. Be sure to keep an eye on market volatility and liquidity while assessing what currency pairs are successful and which pricing models you should trade within.
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