Before we discuss currency spread, it is important that we first understand how foreign exchange market works. In the FX transactions, currency is paired such that the relative value of one currency is denominated in the units of the other currency. The exchange rate in the international market depends on the customer’s willingness to purchase the quote currency what is known as BID. A bid is the highest buying price of the currency pair. The price of the quote currency is known as the ASK. Ask is the lowest price that a given currency pair is to be sold.
All the countries in the world, whether large developed countries or poor third world countries, have their own monetary currency. In the primitive era, gold was the dominion that determined the richness of a person. But as times changed, countries have developed their own systems for monetary exchange.
- US Dollar
- Sterling Pound
- Canadian Dollar
- Indian Rupee
- Saudi Riyal
- Dinar etc.
All these currencies on their own have proved an effective way of dealings and happenings, as opposed to the previously implemented Barter system. But what if you want to buy something from an American and you are a European National? How can you determine which currency has more value? Obviously, to you, Euro is more valuable, but to the seller, his beloved Dollar is more precious. This is the reason; terms like exchange rate and FX spread were first coined.
In terms of finance, an exchange rate is defined as the rate at which one currency can be exchanged in favor of another currency. As mentioned before, it also helps gauge the value of one currency in a country other than itself.
What is FX spread
FX spread is actually the difference between the price at which an entity is bought and the price at which it is sold (Here, entity means, “Currency”). Spread is the difference between the two prices, the price that the market gives to buy from the trader and what the trader gives to buy from the market.
The reflex action of people is to buy and sell the currency immediately, which means there has been no change in the exchange rate, but this result in the loss of money. Reason being, the buy price is always lower than the selling price.
As in, the EUR/USD currency rates at a bank may be 1.0001/1.3001. This signifies a difference of 1000. This difference is considered to be extremely high in comparison with exchange rates for online Forex financiers, such as 1.0001/1.005, a difference of 4.
Bid and ask price
Bid is normally lower than Ask. The difference that comes between Bid and Ask is what is known as Spread. It is important to note that we have fixed and variable spread. Fixed currency spread is the difference between Ask and Bid and is not dependant on the market conditions. The dealing companies set the fixed spread. On the other hand, the variable spread fluctuates in relation to the market conditions. When the market activity is low, a variable spread is also low with approximately one or two pips, but when the market is volatile, it can rise to more than 40 pips. This is what brings uncertainty in the FX transactions.
Factors influencing currency spread in Forex trading
Several factors influence offer bid size in Forex trading. Currency liquidity is the most important of them all. Popular currencies pairs are always traded with low spreads while rare currencies have higher pips. The other factor that influences the spread is the amount of money transacted. When the market is volatile, the bid offer spread is higher than during quiet market conditions. Nowadays, Foreign exchange market is highly competitive because brokers are getting closer to the customers, for this reason, currency spreads tend to be fixed and remain at the lowest level possible.
Traders need to pay close attention to currency spread management. The successful trading strategy should be based on effective market evaluation and specific financial conditions. Because currency spreads are subject to high volatility spread management should include market tools such as risk analysis, forecasting, complex analysis, and transaction cost evaluation.
How to manage currency spread
• Trade at favorable trading hours, this is the time when most sellers and buyers are in the market. When there are many sellers and buyers of a given currency pair, it increases the competition in the market which increased the spread.
• You should also avoid selling and buying thinly traded currencies. Market markers compete to trade the popular currencies such as the US dollar or the Sterling Pound. When you trade in the thinly traded currency pair, you will only get few market markets, and this lessens the competition.