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In forex trading, a spread is the difference between the bid and ask price of a currency pair, representing the cost a forex trader faces when entering and exiting a trade. The bid price is the rate at which you can sell the base currency, and the ask price is what you would pay to buy it. The spread is a critical aspect of forex trading as it affects the profitability of your trades.
What determines Forex Spreads?
The spread in forex trading is primarily determined by market liquidity and volatility. Highly liquid forex pairs like EUR/USD often have tighter spreads, while exotic pairs with less trading volume typically have wider spreads. Market volatility also plays a crucial role; during times of economic uncertainty or major news events, spreads can widen as forex brokers adjust to the increased risk.
Additionally, the type of broker and their internal pricing policies can significantly affect spreads offered to traders.
What is a Pip in Forex Trading?
A pip in forex stands for 'percentage in point' and is the smallest price movement that an exchange between the two currencies that make up a pair can make. Pips are typically represented in the fourth decimal place of the currency pair, or 1/10,000th of the quoted currency.
For most currency pairs, this equates to 0.0001, but for forex pairs involving the Japanese yen (JPY), a pip is the second decimal place, or 0.01.
Understanding pips is essential when you start forex trading, as they are the standard unit for measuring how much the exchange rate has changed between two currencies.
Calculating bid/ask Spreads
Calculating the bid/ask spread, a key aspect of forex trading, involves understanding the difference between the buying and selling prices of currency pairs. Here are examples using the EUR/USD, AUD/USD, and USD/JPY to demonstrate how spreads are determined.
EUR/USD Spread example
Let's consider the currency pair EUR/USD. Suppose the quote for this pair is 1.1200/1.1205. In this quote, the Euro is the base currency, and the US dollar is the quote currency. The first number is the 'bid' price, which means you can sell one Euro for 1.1200 US dollars. The second number is the 'ask' price, which is the price at which you can buy one Euro for US dollars.
The difference between these two prices is the spread (1.1205 - 1.1200 = 0.0005 = 5.0. pips).
AUD/USD Spread example
Now, let's take the AUD/USD forex pair. Imagine the quote is 0.7100/0.7104. Here, the Australian dollar is the base currency and the US dollar is the quote currency. The spread is the difference between the ask and bid price, which equals:
AUD/USD spread = 0.7104 - 0.7100 = 0.0004 = pips.
To understand a price movement, pretend the AUD/USD pair moves from 0.7100/0.7104 to 0.7105/0.7109.
- The bid price (buy price) has increased by five pips (0.7105 - 0.7100)
- The ask price (sell price) has increased by 5 pips (0.7109 - 0.7104)
- This indicates a strengthening of the Australian dollar against the US dollar
USD/JPY Spread example
To illustrate how the pip for yen pairs is quoted in the second decimal place, let's imagine you are trading the USD/JPY forex pair. Suppose the quote is 110.50/110.55. In this quote, the US dollar is the base currency, and the Japanese yen is the quote currency.
This means you can sell one US dollar for 110.50 Japanese yen or buy one US dollar for 110.55 Japanese yen.
USD/JPY spread = 110.55 - 110.50 = 0.05 = 5 pips
Types of Spreads
Forex spreads are categorised into two main types (fixed and variable spreads), with each being associated with different trading strategies and broker models.
- Fixed spreads: remain constant regardless of market conditions. Typically, these are only offered by market makers or brokers with a dealing desk.
- Variable spreads: also known as floating spreads, fluctuate based on real-time market conditions and are typically offered by non-dealing desk brokers but also brokers with a dealing desk.
Fixed Spreads
Fixed spreads remain constant regardless of market conditions (though some brokers may change these in extreme circ*mstances). These types of spreads are offered by market makers and brokers with a dealing desk model. Market makers offering fixed spreads use their internal liquidity. Liquidity providers don't offer fixed spreads, which means no-dealing desk brokers have no option but to tighten and expand their spreads as liquidity fluctuates.
Using their internal liquidity, dealing desk brokers can control their clients' prices and maintain fixed spreads. An advantage of fixed spreads is that trading costs are predictable for beginners; however, they can lead to requotes during periods of high volatility. If the actual market price differs significantly from the broker's fixed spread, the broker may fail to execute a trade at the initially quoted price, resulting in a requote.
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Variable Spreads
Variable or floating spreads, on the other hand, reflect the real-time supply and demand for currencies. Forex brokers offering variable spreads usually operate using a no-dealing desk (NDD) model. Brokers using a dealing desk model do sometimes offer variable spreads, however, so be sure to read the specifics of your preferred account type before starting to trade. NDD brokers obtain pricing from multiple liquidity providers, meaning spreads can widen during major economic releases or times of low liquidity.
Variable spreads provide more transparent pricing and eliminate requotes, but more volatile markets can mean difficult-to-predict trading costs. Traders should also be aware of the risk of slippage with variable spreads, as rapid price movements can lead to a difference between the expected execution price and the actual executed price of a trade.
Scalpers and high-volume traders often prefer variable spreads, as they typically comprise the lowest spreads available in forex markets at any given time.
Which is better? Fixed or Variable Spreads?
The type of broker you choose - whether one with fixed spreads or variable spreads - can significantly impact your trading costs and strategy. Fixed spreads tend to be higher spreads to compensate for the risk the brokers take by acting as the counterparty to your trade, while variable spreads are typically lower, as the prices are passed from multiple liquidity sources.
How to find Low Spreads
1. Research and Compare Brokers
Start by researching various forex brokers. Most publish their average or minimum spreads on their websites. Review websites that compare forex brokers can be useful as well, as they often collate and publish recently advertised spreads and compare these to the current industry average.
You can find out more about the Best Forex Brokers in Australia here.
2. Understand Trading account types
Brokers tend to offer two main account types and pricing structures: no commission and commission-based accounts.
- Commission Accounts: often dubbed 'Raw' or 'ECN' Accounts, this pricing structure is favoured by high-volume traders thanks to lower spreads. However, you pay a set commission fee for each trade. For major currency pairs, spreads of 0.0 to 0.1 pips are considered very competitive.
- No Commission Accounts: also known as Standard Accounts, spreads are generally wider, but you pay no flat-rate commission fees per trade. Low spreads for this account type would be between 0.6 and 0.8 pips for major fx pairs.
3. Focus on Major Currency Pairs
For beginner traders just starting out, it is recommended to focus on the seven major currency pairs. This is because these pairs are the most traded globally, offering high liquidity and typically the lowest spreads. Major pairs involving strong, stable economies make market movements more predictable compared to minor or exotic pairs.
This predictability, combined with lower spreads, makes the majors an ideal choice for beginner forex traders looking to minimise trading costs and navigate less volatile market conditions.
4. Consider your trading volume and style
Your trading style and volume should influence your choice of account type and spread structure. If you are a high-volume trader or scalper, an ECN commission account may reduce the cost of trading, while beginner traders may find standard no-commission accounts more suitable.
5. Check for additional trading fees and costs
While spreads are the main trading cost involved when engaging in forex markets, do not overlook other potential costs like overnight fees, inactivity fees, and funding fees when you make deposits or withdrawals. These can add up and affect the overall profitability of your forex trades.
6. Use demo accounts to test trading strategies
Demo accounts are a great tool to test spreads in real-time market conditions. This can give you a practical sense of spreads and price movements during different market hours and events.
Forex Trading strategies for beginners
Developing a trading strategy that aligns with your style, spread type, and pricing structure is essential for successful forex trading. There are numerous trading strategies available, depending on whether you want to trade short- or long-term, focus on technical vs fundamental analysis, trade actively or infrequently, and so on.
Here are some common strategies for beginner traders:
- Scalping: Ideal if you prefer short-term trades held for just minutes. Scalping focuses on accumulating small but frequent profits and limiting losses
- Day trading: Suitable if you want to trade for short periods but aren't comfortable with the fast-paced nature of scalping.
- Swing trading: A great strategy if you prefer a mid-term trading style where positions can be held for several days. It aims to profit from changes in price by identifying the 'swing highs' or 'swing lows' in a trend.
- Position trading: Suited to the most patient forex traders, position trading focuses on fundamental analysis and more long-term factors and is less concerned with short-term market fluctuations.
Conducting technical and fundamental analysis
In forex trading, technical and fundamental analysis are two cornerstone approaches used in strategy development. Technical analysis involves examining past market data, primarily price levels and volume, to forecast future price movements. To do this, you use various charting tools, patterns, and technical indicators to identify potential trading opportunities.
On the other hand, fundamental analysis focuses on economic, social, and political factors that may impact currency values. This includes analysing economic calendars and indicators, government policies, as well as financial market sentiment.
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For effective analysis, choosing the right trading platform is vital. Platforms like MetaTrader 4 (MT4), MetaTrader 5 (MT5), and cTrader are the most popular worldwide and widely regarded as the gold standard in the forex trading community. They offer a range of charting tools, customisation options, risk management tools, and backtesting capabilities, which are invaluable when refining your trading strategies.
Additionally, these platforms offer automated trading tools. Also known as algorithmic trading tools, this feature allows you to continuously analyse market data and execute trades around the clock, even when you aren't actively monitoring the markets. This not only increases the efficiency of your trading strategy but also removes any impact your emotions may have on trading decisions.
You can find out more about The Best CFD Trading Platforms in Australia and The Best Forex Platforms here.
When can I trade Forex?
Forex trading is available 24 hours a day, primarily through four major trading sessions in Sydney, Tokyo, London, and New York. Each trading session has specific opening times:
- Sydney Session: Opens at 7 am and closes at 4 pm (Australian Eastern Standard Time, AEST)
- Tokyo Session: Starts at 9 am and ends at 6 pm (Japan Standard Time, JST)
- London Session: Begins at 8 am and finishes at 4 pm (Greenwich Mean Time, GMT)
- New York Session: Open 8 am to 5 pm (Eastern Standard Time, EST)
The New York and London trading sessions are best known for high volatility and liquidity. It is considered a prime time to trade foreign exchange when the two trading sessions overlap between 8 am and 12 pm New York time, which corresponds to 12 am to 4 am Australian Eastern Time (AEST).
How to get started trading Forex
To start trading forex, you'll need to start by choosing a reputable broker and opening a trading account. In Australia, it is advisable to sign up with a broker regulated by the Australian Securities and Investments Commission (ASIC), as this provides you more capital protection than offshore-regulated brokers.
It is also important to look into the range of CFD products outside of foreign exchange available to trade with your selected broker. Once you learn the ins and outs of forex trading, you may want to develop trading strategies involving crypto or stocks down the track, and the range of financial instruments available to trade varies between brokers.
Next, you'll need to develop a trading strategy that aligns with your goals and risk tolerance. It is wise to practise with a demo account to familiarise yourself with forex market dynamics and your chosen strategy.
Once comfortable, fund your account and transition to live trading, applying the insights and experience gained from your practice sessions.
Disclaimer: forex and derivative trading carry a high level of risk and may not be suitable for all retail investors. Consider your objectives and experience carefully before trading forex, and seek independent advice if necessary.
Disclaimer: This story may include affiliate links with PropCompanies partners who may be provided with compensation if you click through. ACM advises readers consider their own circ*mstances and needs. You should verify the nature of any product or service, and consult with the relevant regulators' website before making any decision.
