While forex trading requires you to enter and exit positions at specific times, one critical element you have to keep an eye on is the spread. If you’re engaging in a trading challenge within a prop firm or trading with the help of a funded account, spread costs might significantly affect your trading results. Knowing more about spreads will allow you to become a better trader.
This article will explore the concept of spread costs in easy-to-understand terms, share insights on their significance for funded forex traders, and reveal ways How to calculate spreads in forex trading.
Spread in Forex Trading
In forex trading, the spread is the gap between the ask price and the bid price of a currency pair. Spreads are used by brokers and proprietary trading firms as one of the means of earning money through the transaction.
Example:
- EUR/USD Ask Price = 1.1052
- EUR/USD Bid Price = 1.1050
- Spread = 2 pips
Every time a trader enters into a trade, there will always be an initial loss due to the spread cost, which the market must cover in order for the trade to yield profit.
Spread knowledge is important for funded traders since profit objectives and stop-out rules can be stringent.
Importance of Spreads for Funded Traders
In most cases, funded forex traders work with prop firms that offer certain regulations. These include:
- Daily drawdowns
- Maximum possible losses
- Profit goals
- Trading consistency criteria
Due to such regulations, every pip counts. Wide spreads can decrease profits while increasing trading costs immensely.
If a trader disregards the effect of spreads, he/she may experience:
- Early entry into trades
- Risk mismanagement
- Loss of short-term profits
- Failure in funded trading programs
It is particularly essential for scalpers and day traders due to many transactions made within one session.
Calculating Spread in Forex
One of the frequently asked questions by newbies is how to calculate spread in forex trading. The procedure is straightforward.
Basic Formula
- Spread = Ask price – Bid price
- Spread Calculation Example
Assume that the pair GBP/USD has:
- Ask Price = 1.2745
- Bid Price = 1.2742
The spread will be equal to:
- 1.2745 – 1.2742 = 0.0003 = 3 pips
Assuming that each pip is worth $10 per a standard lot, then:
- 3 * 10 = 30
- The spread cost will be $30.
Two Types of Forex Spreads
Spreads can be mainly categorized into two types.
Fixed Spreads
In case of fixed spreads, spreads will stay unchanged irrespective of any market conditions.
Benefits:
- Predictable cost of transactions
- Easy for new traders to handle
- Effective during less volatile periods
Demerits:
- Usually slightly higher than others
- More rigid during active periods
- Variable Spreads
Here, spreads vary according to market liquidity and volatility.
Benefits:
- Wider spreads when there is activity in the markets
- Best suited for skilled traders
Demerits:
- Spread may widen after news announcements
- More difficult to estimate transaction cost
Prop houses, as well as brokers, providing instant funding facilities, use variable spreads.
How Spreads Impact Profit Target
Traders who use funding will need to meet their profit target within the shortest time possible without exceeding the risk boundaries. Higher spreads mean lower potential profits for traders.
For instance:
- Trades set a profit target of 10 pips
- Spreads = 3 pips
Therefore, the trade will need 13 pips movement in the market to make a profit.
This becomes more vital for:
- Scalpers
- High-frequency traders
- News traders
Spread Expenses and Scalping
Scalping includes making several deals per day. Being that the gain from one deal is minimal, the spread plays an important role.
Example:
- Scalping goal = 5 pips
- Spread = 2 pips
The spread makes up 40 percent of the profit that could be made.
That’s why professional funded traders prefer:
- Large currency pairs
- Sessions with high liquidity
- Banks with low spreads
Lowest Spread Currencies
Most major forex pairs tend to have the smallest spreads as they are highly liquid currencies.
Examples of low-spread currency pairs are:
- EUR/USD
- GBP/USD
- USD/JPY
- USD/CHF
Exotic currencies tend to have wider spreads due to their low liquidity levels.
It is important that a trader who trades on funded accounts concentrates on low spread currency pairs.
Market Session and Spread Variation
There is variation in forex spread at different times of the day depending on the market situation.
Low Spreads Occur At:
- London market
- New York market
- Overlap between London & New York
High Spreads Occur At:
- Market opening
- Market closing
- Significant economic data announcements
Many traders that trade with funding do not participate when there is high volatility of economic news events.
Spread Widening in News Releases
During major news announcements, like:
- Rate announcements
- Non-farm payrolls (NFP)
- Inflation numbers
There could be a sudden spread widening.
What used to be just 1 pip may jump to 10 pips or even higher.
This may result in:
- Setting off stop losses
- More slippage
- Drawdown violations in prop firms
Traders must look at economic calendars prior to trading to avoid spread widens.
Handling Spread Fees in Prop Firms
Not all prop firms trade the same way; some of them include:
- Raw spread + commission
- Normal spread but no commission
- ECN type execution
Before you join a funded trading program, you must check:
- Average spreads
- Commission rates
- Execution time
- Slippage issues
Firms advertising instant funding tend to advertise low spreads.
Tips to Minimize Spread Costs
Trading at High Liquidity
One should always trade at high liquidity levels where spreads are narrow.
Do Not Trade on News Events
Spread levels could increase during news events, which would result in increased risks.
Trade on Major Currencies
The use of major currencies will result in lower spread costs compared to exotic currencies.
Select the Right Broker or Prop Firm
It is important to select a broker that offers low spreads and efficient execution.
Do Not Overtrade
Increased trading will lead to increased spread costs.
Spread Costs and Commission Costs
Some traders pay attention to spreads only without considering commission fees. But both are important.
Consider this scenario:
- Brokerage company A charges 0.5 pip spread + $7 commission fee
- Brokerage company B charges 2 pip spread but does not charge any commission
The overall trading fee could be quite close.
A trader who uses fund in trading must consider all trading fees involved before choosing an appropriate trading platform.
Psychological Impact of Spread Costs
Spread costs also have psychological effects on traders. Beginners usually feel stressed when they begin their trading activity on the negative side.
Such a feeling could lead to:
- Early exit from trades
- Revenge trading
- Over leveraging
By learning about spreads, traders become more relaxed and trade according to realistic expectations.
Conclusion
The calculation of spread costs is one of the vital issues that traders need to know. It is especially critical for traders who use funds in trading. Even the slightest spread could influence profitability.
Calculating the spread cost in forex trading enables traders to estimate trading expenses and choose favorable trading conditions.