When you first start trading forex,
you’ll hear a lot of different terms that might confuse you. One of the most
important but often misunderstood terms is spread. You might have heard
it mentioned by other traders, or maybe you’ve come across it while trying to
analyze your trades. But what does it really mean, and how does it impact your
trading?
In this article, I’ll break down
what a forex spread is, how it affects your trades, and most importantly, how
you can stop overpaying for your trades. Trust me, I’ve been there, and I know
how frustrating it can be to feel like the market is working against you before
you even get started. But once you understand spreads, you’ll have more control
over your trades and can make better decisions.
What Exactly Are Forex Spreads?
Let’s start with the basics.
A spread is the difference
between the price at which you can buy a currency pair (the ask price)
and the price at which you can sell that currency pair (the bid price).
It’s like a hidden cost that you pay every time you open a trade.
Think of it like a markup or
markdown on the actual price of the currency pair you want to trade. If you
want to buy EUR/USD, and the price is 1.1000, the broker might offer you a
slightly higher price, say 1.1002. That extra 0.0002 is the spread. If you
wanted to sell EUR/USD, they might offer you a price like 1.0998. Again, the
difference is the spread.
Here’s a simple example:
- EUR/USD (Buy Price): 1.1002
- EUR/USD (Sell Price): 1.0998
- Spread: 0.0004 (4 pips)
The wider the spread, the more it
costs you to enter and exit the market, and this can eat into your profits.
How Does Spread Affect Your Trades?
Now, you might be wondering: How
does this affect my trade?
Let’s take a moment to think about
it.
When you enter a trade, you’re
immediately at a disadvantage because you’re either buying at a higher price or
selling at a lower price. This means that, just by opening a position, you’re
already in an unrealized loss.
For example, if you buy EUR/USD at
1.1002 and the market price is 1.1000, you’re already in a 2-pip loss. The
price needs to move in your favor by at least 2 pips for you to break even. And
if you’re trading with tight stops or small timeframes, this can cause big
problems.
Personal Experience: The Spread
Battle
I remember a time when I was trying
to scalp the market. For those of you who don’t know, scalping is a strategy
where you open and close trades in a very short period, often within minutes. I
was using a broker with a wider spread, and every time I entered a trade, I
felt like I was already in the red.
I’d enter a buy order for EUR/USD,
and the price would be 1.1002, but the market price was only 1.1000. My trade
immediately started in a loss, and that made it so much harder to profit from
small price movements. After a few trades, I got frustrated and realized that I
was paying for those spreads even when the market moved in my favor.
The wider the spread, the harder it
is to make money. And if you’re scalping, those tiny profit margins can quickly
disappear because of spreads.
Fixed vs. Variable Spreads - Which One Is Better for You?
One of the key things to consider
when it comes to spreads is whether the spread is fixed or variable.
Let’s take a look at both:
1. Fixed Spreads:
- What They Are: The spread remains constant,
regardless of market conditions.
- Pros: You know exactly what you’re paying
for the spread, and it’s predictable.
- Cons: Fixed spreads are usually higher than
variable spreads, especially during normal market conditions.
2. Variable Spreads:
- What They Are: The spread changes depending
on market conditions, such as liquidity and volatility.
- Pros: You may get lower spreads during times
of high liquidity (like during the London or New York sessions).
- Cons: They can widen during news events or
times of low liquidity, which can result in higher costs.
The Problem with Spreads - When They’re Too Wide
Sometimes spreads can get so wide
that they cause problems for your trades. This usually happens during periods
of low liquidity or high volatility. For example, when the market
is quiet or when there’s a major news event, the spread can widen dramatically.
This is something that happened to me recently while trading GBP/JPY.
Personal Experience: GBP/JPY
Woes
I’ve noticed that the
spread on GBP/JPY has been unusually high—around 3 pips, compared to less than
1.5 pips in the past. This wider spread has caused me to get stopped out
unexpectedly, even though my strategy was solid. The market would move in my
favor, but the larger spread would eat into my profits or even push me out of
my position before the price could reach my target.
It felt like the market was working
against me, and I started questioning my strategy. But once I realized that the
higher spreads were to blame, I knew I needed to adjust my trading style and be
more cautious during volatile times.
How to Avoid Overpaying on Spreads?
So, what can you do to stop
overpaying on spreads? There are a few things you can do to minimize the impact
of spreads on your trades:
1. Choose the Right Broker:
Not all brokers offer the same
spreads. Some brokers offer tighter spreads, especially during times of high
liquidity, while others might have wider spreads. Do your research and choose a
broker with low or zero spreads if possible.
2. Trade During Active Market Hours:
Spreads tend to be narrower when
the market is active, especially during the London and New York trading
sessions. If you trade during quieter times, such as the Asian session, the
spread can widen considerably. Try to trade during the more active hours to get
the best spread deals.
3. Avoid Trading During News Events:
While news events can provide
trading opportunities, they also tend to cause volatility, which can lead to
wider spreads. If you’re not prepared for the volatility, it’s better to avoid
trading during major news releases or economic reports.
4. Use Limit Orders:
A limit order can help you avoid
getting filled at a price worse than you wanted. When you place a limit order,
you set the price at which you’re willing to buy or sell, ensuring that you
only get filled at a price that works for you.
5. Adjust Your Position Size:
If you’re trading with a wider
spread, consider adjusting your position size. By reducing your position,
you’ll minimize the impact of the spread on your trade. Smaller trades can help
you manage the cost of wider spreads.
Fixed vs. Commission-Based Accounts - What’s the Best Choice for You?
Another important decision you’ll
need to make is whether to trade with a spread-based account or a commission-based
account. Here’s a breakdown of both:
1. Spread-Based Accounts:
- How They Work: You pay a spread on each
trade, and there’s no extra commission. The broker makes money through the
spread.
- Best for: Longer-term trades or strategies
that don’t require frequent transactions.
- Drawback: If you’re a scalper or trade
frequently, the spread can eat into your profits, especially if it’s wide.
2. Commission-Based Accounts:
- How They Work: The broker charges a fixed
commission on each trade, but you get tighter spreads.
- Best for: High-frequency traders or scalpers
who need tight spreads to profit from small price movements.
- Drawback: If you’re not trading frequently,
the commission can add up quickly and reduce your overall profitability.
The Role of Volatility & Spreads
Volatility is a big factor when it
comes to spreads. When the market is volatile, spreads can widen, and this is
something you’ll need to be aware of. If you’re trading during times of high
volatility, like during market opens or news events, the spread may increase
dramatically.
Personal Insight on Volatility:
I’ve learned through experience
that if you’re trading in volatile conditions, you need to adjust your
expectations. I’ve gotten caught up in the excitement of quick price moves,
only to be stopped out by an unexpectedly wide spread. It’s a good idea to check
the spread before entering a trade and avoid trading during periods of high
volatility unless you’re prepared for the risk.
Conclusion - Take Control of Your Trading Costs
Understanding spreads and their
impact on your trades is crucial if you want to become a successful forex
trader. By choosing the right broker, trading during the right times, and
adjusting your strategy based on spread conditions, you can minimize the hidden
costs and make more informed decisions.
Remember, spreads are a part of
trading, but they don’t have to work against you. Once you understand how they
work and how to manage them, you’ll be better equipped to navigate the forex
market and improve your overall profitability.
In the end, trading is all about
making smart, calculated decisions. Spreads are just one of many factors to
consider, but they can make a huge difference in your success, especially when
you’re trading on smaller timeframes or with tight profit margins. By taking
the time to learn how spreads work and how to manage them effectively, you’ll
have a better chance of avoiding unnecessary losses and boosting your profits.
So, what’s your next move? It’s
time to take control of your trading costs and start making spreads work for
you—not against you.
Quick Tips for Managing Forex
Spreads:
To wrap up, here’s a list of key
takeaways that will help you manage spreads like a pro:
- Choose a Broker with Tight Spreads: A good
broker can make all the difference in the cost of trading. Look for one
that offers low spreads, especially on major currency pairs.
- Trade When Liquidity is High: Aim to trade
during the most active market hours, like the London and New York
sessions, to take advantage of tighter spreads.
- Use Limit Orders: Set your entry and exit
points with limit orders to avoid getting filled at a worse price due to
spread fluctuations.
- Avoid Major News Events: Stay away from
trading around big news releases, as these can cause spreads to widen
unpredictably.
- Check the Spread Before You Trade: Always be
aware of the spread before you enter a trade. If it’s unusually wide,
consider waiting for a better time to trade.
- Adjust Your Position Size: If spreads are
wider than usual, consider reducing your position size to minimize the
impact on your trades.
Final Thoughts on Spreads
Trading forex isn’t about luck—it’s
about strategy and understanding the tools at your disposal. One of those tools
is the spread. By being aware of how it works and how it can affect your
trades, you can improve your chances of making a profit. With practice, you’ll
get better at spotting the best times to enter and exit trades based on the
spread, and you’ll have a more solid understanding of how it influences your
overall trading strategy.
The more you learn and adjust your
strategy based on spreads and other market conditions, the more you'll develop
your skills as a trader. Don’t let spreads overwhelm you; instead, use them as
an opportunity to refine your approach. After all, trading is all about
adapting to the market and using every piece of information at your disposal to
make smarter decisions.
Now that you have a better
understanding of forex spreads, it’s time to put this knowledge to work. Test
it out in your paper trading account, experiment with different brokers, and
see how spread management can help you boost your trading success. Remember,
success in forex doesn’t happen overnight, but with the right strategies and a
bit of patience, you’ll get there!