Before we proceed to learn, what is spread, we need to know what is Bid and ask price in trading.
The bid price is the price in which buyers are willing to pay for trading security.
Ask price (offer price)
The ask price is the price that sellers are willing to receive for trading security.
More simply, suppose you want to buy USD and you are a European citizen traveling to the USA. You need to convert your euro to the local currency. Thus you will buy USD with your existing euro.
If EURUSD is quoting at 1.2510, that means it’s the bid price, which you need to pay to buy USD with your euro.
You will see another quoting price of EURUSD, which is the Ask price 1.2512. That’s the price that the seller will receive if he sells his USD to you.
A common thought can arise in mind, why there is a significant difference between the bid and ask price? Well, we will explain it in next.
What is Spread?
Spread is the difference between bid and ask price. With the example above, for EURUSD spread was 0.0002 i.e 2 pips. Spread the is the cost which trader carries and brokers or exchanger earns. Spread is always a transaction cost for traders.
Some forex brokers promote their brokerage services with the lowest spread on EURUSD or other major pairs to draw trader’s attention. Because the lower the spread is, the better the profit will be, trader’s cost per trade will decrease.
Spread in profit loss calculation
Suppose a trader bought EURUSD at 1.2510, this price will be the Ask price. Upon closing the buy position of EURUSD, the trader needs to sell it to someone else with the bid price.
Suppose a trader bought EURUSD at 1.2510, this price will be the Ask price. Upon closing the buy position of EURUSD immediately, the trader needs to sell it to someone else with the bid price of 1.2508. Two pips difference is the spread.
If a trade closes in profit then spread will get subtracted from the profit and in case of loss of trade, the spread will get added to the loss.
Suppose you made 20 pips, then deducting 2 pips spread, it will be 18 pips profit.
With 10 pips loss and adding 2 pips spread with it, it will be a total 12 pips loss.
Learn more about earning profit in forex trading, check chapter 11.
The spread varies from currency pairs to currency pairs. The currency pairs with lower liquidity or trading volume have a higher spread and currency pairs with higher liqudity or trading volume have a lower spread.
Most of the forex broker promote their brokerage service with competitive lower spread or zero spread with major currency pairs.
Learn more about forex liqduity from chapter 4
Sometime during news release forex spread gets increased for majority brokers. Little change is affordable. But too much change can cost a lot of money for a trader.
This is a bad practice among scam forex brokers. They change spread too high in a fraction of second which creates damage in a trader open position. Because their stop loss gets hit so easily. That’s why it is safe not to place any trade during major forex news releases or any political events unless you are using a straddle strategy.