What is a Spread in Trading, and How Does It Affect Your Trades?
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When you first dive into the world of forex, you may often hear the term “spread.” But what exactly is a spread? Well, in this article, we’re going to discuss the concept of what is a spread in trading and its impact.
What is a Spread in Trading?
The bid price is the price at which a trader can sell a currency, while the asking price is the price at which a trader can buy a currency. The spread, on the other hand, represents the difference between these two prices. Spread refers to the difference between the buying and selling prices of a currency pair between the trader and the broker.
Psst... Spread is How No Commission Broker Make Money
When you’re trading, the forex broker provides you with two different prices: the bid price and the asking price. The bid price is the price at which a trader can sell a currency, while the asking price is the price at which a trader can buy a currency. So spread is like a transaction cost.
Since brokers provide services to traders, they also aim to make a profit. Simply put, brokers make a profit by:
- Selling currency to you at a higher price than the cost they incurred to buy that currency.
- Buying currency from you at a lower price than the price they intend to offer to other traders.
How to Calculate Spread?
After understanding what is a spread in trading, it’s time to delve into how it’s calculated. In reputable brokers, the spread is usually measured in pips. A pip is the smallest incremental change in the value of a currency pair. The value of a pip is typically seen as the fourth decimal place in the price of a currency. For example, if the value of 1 Euro is $1.0521 and it increases to $1.0522, it means there was a movement of 1 pip because the fourth decimal place moved one point or increased by 0.0001 USD.
What is the Impact of Spread in Forex Trading?
As a beginner trader, understanding what is a spread in trading is crucial because, like it or not, it can significantly influence the success of your forex trading. Here are some of its effects:
- Trading costs: Spread can increase trading costs. Traders who frequently open and close positions within a short period (short-term traders) may be greatly affected if the spread widens.
- Profits: Due to widening spreads, the profit you initially gained may suddenly disappear. For example, if you made a profit of 3 pips in a trade, but the spread is 2 pips, it means you have to pay an additional 2 pips when buying and 2 pips when selling. This means that despite the initial 3 pips of profit, you would actually incur a loss of 1 pip (3 – 4).
Types of Spreads in Forex
1. Fixed Spread
A fixed spread remains the same regardless of market conditions or stability. Even during periods of high market volatility, the cost of the spread remains constant. Fixed spreads have some advantages, such as stability and consistency in value. Traders can easily manage their money consistently because they can predict transaction costs.
However, fixed spreads have a disadvantage known as “requote.” This occurs when the broker cannot process the order at the requested price due to sudden market fluctuations. For example, if you wanted to buy EUR/USD at a price of 1.2100, but the market price suddenly changed to 1.2105 before the order could be executed, the broker would block the request and ask you to buy at the new price.
2. Floating Spread
Unlike fixed spreads, floating spreads change according to market movements. The cost of the spread fluctuates based on market conditions. Floating spreads have several advantages, including no possibility of requotes, as the spread adjusts to market movements. Additionally, there is a potential for the spread to narrow when market liquidity is high, resulting in lower trading costs.
On the flip side, the disadvantage of floating spreads is the uncertainty of spread costs. Traders cannot know for certain the exact amount they will be charged. There is also a risk of spread widening during unfavorable market conditions or when prices continue to rise.
Understanding the what is a spread int trading, the different types of spreads and their impact on trading costs and profits is essential for effective forex trading. It allows you to make informed decisions and manage your trading strategies accordingly.
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