As any seasoned forex trader knows, calculating spreads is crucial for understanding the cost of trading currencies. While forex brokers advertise low commissions and wide spreads as selling points to attract new traders, what matters is doing the math yourself to see what you will pay in the trade. It is all too common for forex newbies to miss out on potential profits or even sustain trading losses simply because they need to take the time to crunch the numbers on trade spreads. In this article, we will walk through the simple steps to calculate forex spreads using real examples to gain transparency into an often opaque part of the forex trading process. By understanding how to evaluate trade spreads quickly, you will be empowered to make more informed decisions and optimise your strategies for maximum profit potential.
If you are looking to trade in the UAE, you should work with a reputable forex trading broker. They should be authorised and regulated by the SCA, and they should have a strong track record of working successfully with clients.
Understand what forex spreads are and how they impact your trades
Before delving into the calculations, it is essential to clearly understand what exactly what forex spreads are and how they affect your trades. Spreads refer to the difference between a currency pair’s bid and ask price. The bid price is what buyers are willing to pay for a particular currency, while the ask price is what sellers are willing to accept. For example, If the EUR/USD currency pair has a bid price of 1.1000 and an ask price of 1.1005, the spread would be 0.0005 or 5 pips.
Spreads are the transaction cost for trading currencies, commonly called ‘trading fees’. They can vary depending on the currency pair, market conditions, and the broker you are using. Understanding spreads is crucial because they can significantly impact your profits or losses on a trade. A wider spread means higher transaction costs for you, making it more challenging to profit. A tighter spread means lower transaction costs and potentially greater profitability.
Calculate the bid-ask spread using a currency pair quote
You must look at a currency pair quote on your trading platform to calculate the bid-ask spread. As mentioned earlier, the bid price is what buyers are willing to pay for a currency, and the ask price is what sellers are willing to accept. Typically, these prices are displayed as two separate numbers, with the bid price always being lower than the ask price.
For example, consider the AUD/USD currency pair quote: 0.7606/0.7612. The bid price here is 0.7606, and the ask price is 0.7612. To calculate the spread, subtract the bid price from the ask price: 0.7612 – 0.7606 = 0.0006 or 6 pips.
Consider how trade size can affect the spread of your transaction
It is important to note that the spread can vary depending on your trade size. The larger the trade size, the more likely the spread will widen. This is because larger trades require more liquidity from the market and, therefore, come with higher transaction costs.
For example, if you are trading a standard lot (100,000 units) of EUR/USD, you may see a spread of 2 pips. However, if you are trading a mini lot (10,000 units), the spread may be as high as three pips. It is essential to consider trade size when evaluating spreads, as it can significantly impact your overall transaction costs.
Investigate factors that cause spreads to widen or tighten over time
Spreads are not fixed and can vary over time due to various factors. Understanding these factors can help you anticipate potential spread changes and make more informed trading decisions. One factor that can affect spreads is market volatility. When the markets are highly volatile, spreads tend to widen due to increased uncertainty and risk for brokers. It means higher transaction costs for traders during this time.
Another factor is the time of day. Liquidity and trading volume tend to be higher during specific trading sessions, such as when major financial markets overlap. During these times, spreads can be tighter due to increased liquidity in the market. Lastly, economic events and news releases can also impact spreads. Significant events or announcements can cause market volatility, leading to wider spreads as brokers adjust their prices to reflect market sentiment.
Look at a currency pair graph to visualise how spreads fluctuate
To better understand how spreads can change over time, looking at a currency pair graph can be helpful. These graphs show the price movements of a currency pair over a specific period and include the bid-ask spread. By looking at these graphs, you can see how spreads have changed in the past and potentially identify patterns or trends.
For example, spreads tend to widen consistently during certain market conditions or events. It can help you plan your trades accordingly and potentially avoid higher transaction costs.
