Calculating the forex spread for a currency deal
The foreign exchange (abbreviated as forex) market is the largest financial market, and there are many companies, traders, and dealers who are buying and selling different currencies. Usually, the buyer and seller of forex will not deal directly with each other; they will use a trader or dealer’s services to purchase or sell the currencies they require. The trader purchasing the currency will specify the maximum amount he will pay, which is the bid price. Similarly, the dealer who is selling the currency will also indicate the lowest price for which the currency will be sold.
Forex Spread definition
What is spread in the forex? The forex spread, also called the bid-ask spread, is the difference between the bid and the ask prices for a specified currency pair. Spread is the difference between the exchange rate that a forex broker sells a currency and the rate at which the broker buys the currency.
The forex traders and dealers are aware that different companies and organizations worldwide are valuing each country’s currencies differently based on demand and supply. Hence using the information which they have, they are selling and purchasing currencies. The forex trades exploit the fact that the information in the market is asymmetrical, all traders and dealers do not have access to the same information, and this will affect the trading decisions they take
Forex spread Formula
The Forex spread is usually calculated as a percentage, and the formula for the forex spread cost calculator is given below
Spread % = ((Ask price – Bid price)/Ask price) X 100
where for the specific deal
Ask price is the lowest price for which the dealer will sell currency units
The bid price is the highest price for which the trader will purchase currency units for the deal.
Spread in currency trading
Theoretically, the price at which a trade should take place is the midpoint of the forex spread. This midpoint is calculated by adding the bid and ask price for the deal and getting the average by dividing the sum obtained by two. Since the currency prices are changing rapidly, the trader and dealer are taking some risk selling and buying currencies, and the spread compensates the traders, dealers for the risk they take.
The Cost of the Spread
When trading a 10k EUR/USD lot, you would incur a total cost of 0.00005 (0.5pips) X 10,000 (10k lot) = $0.5. If you were trading a standard lot (100,000 units of currency) your spread cost would be 0.00006pips (0.5pips) X 100,000 (1 standard lot) = $5.
The average spread in forex is around 0.5 till 1 pip for major currency pairs and can be 10 pips and more for exotic currency pairs when volatility is high, and liquidity is small.
Factors affecting forex spread for deals
The forex spreads are affected by many factors, which vary depending on the currency pair being considered. Some of these factors are discussed below.
A lot of stock traders are surprised when they see small commissions in the forex industry. If you are a scalper trader, then you will say, “why are forex spreads so high?”. Anyway, spreads are defined by brokers, and traders can only change the broker.
Usually, when trading volumes are higher, it indicates that there is more liquidity in the market. This also usually implies that the bid-ask spread will be lower. When the forex spread decreases, the difference in the dealer’s valuations, the buyer of the specific currency will also decrease. Hence forex dealers will find it easier to find a buyer whose bid price is similar to their ask price and finalize the trade. Similarly, for liquid markets, currency buyers find it easier to find dealers, accepting their offer to purchase the currency at the specified price. Usually, forex spreads will be higher when trading volumes are lower since dealers, buyers will find it more difficult to find a trade partner for the currency at the price they specify
Political and economic risks
In countries where the economy and the political climate is not stable, the currency is usually associated with greater risk since its value can fluctuate frequently. In these countries, the inflation rate is typically higher, and the monetary policy approach is not very disciplined. Hence for the currencies of these countries, the forex spread will be higher. Due to economic conditions, the dealers will consider the currency of these countries as a risky investment. They will sell the currency at a higher price to compensate for the risk. Similarly, the buyers will also want to purchase the currency at a discounted price to compensate them for the risk which they are taking. So the bid-ask spread will increase in these economies, reducing the forex trade volumes.
The exchange rate for a country’s currency depends largely on having a stable central bank and monetary policy discipline. If the central bank is not stable and undisciplined, the currency exchange rate will change more often. Hence to compensate for the risk they are taking, the dealers will increase the asking price for the currency, and this will also make the forex spread for the currency higher.
Why is forex spreads so high?
When we have emerging markets currency pairs (such as exotic pairs and non-major forex pairs), then we have high spread (the large difference between the bid and the asking price), and the main reason for that is high volatility in the market and/or low liquidity for that currency pair.