When one starts trading in financial markets, he or she is bound to get into terms like pip, leverage, margin, and spread, but may not understand their significance initially. There is no doubt that all such terms require to be learned for better trading. However, there is one term that must definitely come first for beginners to know about – the answer to what is a spread in trading.
Spread can be defined as an extra cost paid upon entering financial market transactions regardless of the type of market, such as forex, stock, commodity or index. Knowing everything about what is a spread in trading can help you trade more efficiently, save money and perform better as a trader especially in case of a funded account.
This article aims at explaining the key things one should know about spreads and ways to deal with them.
What is Spread in Trading?
In order to learn about what is a spread in trading, you should have knowledge about the bid price and ask price first.
Bid Price: Price at which the buyers will buy.
Ask Price: Price at which the sellers will sell.
Difference between these two prices will be known as spread.
Let's assume:
- EUR/USD Bid Price = 1.1050
- EUR/USD Ask Price = 1.1052
- Spread in this case will be 2 pips.
In simpler words, spread can be understood as the transaction cost of the brokers on your trades. When you make an entry into a trade, then most likely you'll enter with a loss amounting to the spread.
Spreads in Trading Importance
Newbies often do not consider spreads at all when starting trading, but spreads can affect profitability greatly.
The more trades a trader executes each day, the more he can lose on spreads alone. The higher the spread, the more costly trading is.
It is essential to know what is a spread in trading for traders that use funded accounts, since prop firms usually impose strict risk management rules and expect profitable trading.
High spreads could lead to:
- Reducing profits
- Increasing losses
- Activating stops early
- Making it hard to scalp
- Affecting trade execution
That is why professional traders constantly check spreads before opening positions.
Two Types of Spreads in Trading
The two main types of spreads traders will experience in their trades include:
Fixed Spreads
In this case, spreads do not vary based on the market situation. Typically, those that offer fixed spreads have relatively constant spreads in times of calm markets as well as volatile markets.
- Pros of Fixed Spreads
- Consistent cost of trading
- Easier to manage
- Best for stable risk management plans
- Cons
- Usually wider than variable spreads
- Not flexible in times of calm markets
Fixed spreads are more favored by beginners since they tend to be consistent.
Variable Spreads
These vary depending on the market situations such as volatility and liquidity.
The spreads can become quite wide in times of extreme volatility while becoming very tight when there is little volatility.
- Pros of Variable Spreads
- Cheaper spreads in times of normal market situations
- Favored by active traders
- Best for scalpers
- Cons
- Can widen up suddenly
- Risky during news releases
Professional traders and funded account traders are mostly fond of variable spreads due to low spreads.
Spread Measurement in Forex Trading
Spreads in forex markets are usually quoted in pips.
A pip is the minimum change in price for most currency pairs.
For instance:
- EUR/USD changes from 1.1000 to 1.1001
- This is equal to one pip.
- When the broker quotes:
- Bid: 1.1000
- Ask: 1.1002
- The spread will be two pips.
Many brokers have started offering prices in fractions of a pip, known as pipettes.
Factors Influencing Spread Size
There are several factors affecting spreads in the market.
Market Liquidity
A liquid market tends to have smaller spreads.
For instance,
- EUR/USD spread is usually extremely small.
- Exotic pairs tend to have wider spreads.
- Liquidity increases spreads.
Market Volatility
A volatile market can cause larger spreads.
On occasions where there are:
- Interest rate changes
- Economic reports released
- Employment reports released
The broker might widen spreads since prices can move unpredictably.
Trading Sessions
Different sessions result in various spread sizes.
Usually, the smallest spread is during:
- London market session
- New York market session
- London/New York market session crossover
Wider spreads are observed during low volume times like late Asian trading session.
Type of Broker
Different brokers have different spread offerings.
Some brokers:
- Offer wider spreads without any commissions
- Provide raw spreads and charge commission fees
- Compare brokers carefully before choosing one.
Spreads versus Commissions
New traders often misunderstand spreads for commissions.
Spread
It is an inherent gap between the buying and selling prices.
Commission
An additional charge applied separately by certain brokers.
For instance:
- Broker X may have a 2-pip spread with zero commission
- Broker Y may apply a 0.2-pip spread with a commission
Professionals favor low spreads along with commissions because the overall cost may be reduced.
Impact Of Spreads On Your Profit
For example, you open a buy position on EUR/USD at a 3-pip spread.
Your market should go up 3 pips before your start seeing any profit.
In case you trade under unfavorable spreads quite often, it will be hard to make money.
It’s critical if you trade:
- Scalping
- Day trading
- Funded accounts
Given that all funded account programs have drawdown limits, it might be beneficial to lower spread expenses.
Best Trading Strategies in Spreads
What Is Spread in Trading? Explaining what a spread is in trading is also vital for selecting suitable trading strategies.
Scalping
Scalpers trade on small profits, meaning that low spreads are highly important for them.
High spreads may ruin their profit expectations from short-term trading.
Day Trading
Traders who prefer day trading will appreciate trading when the market offers good liquidity, which means low spreads.
Swing Trading
For swing traders, spreads are not as crucial as they are for scalpers. Nevertheless, selecting low spread assets enhances profitability.
How Can Beginners Cut Down Their Spread Costs?
Here are a few ways beginners can minimize spread costs while trading.
Trade in Major Currency Pairs
Pairs such as:
- EUR/USD
- GBP/USD
- USD/JPY
are typically offered at reduced spreads owing to liquidity.
Stay Away from News Announcements
Significant events can sometimes make the spread extremely wide.
Beginners must stay away from trading when major economic announcements are expected.
Choose a Good-Faith Broker
A reputable broker offers:
- Lower spreads
- Quick executions
- Transparency
Poor brokers may exploit the volatile environment to increase spreads.
Trade During Busy Trading Sessions
The lowest spreads can be found during:
- London hours
- New York hours
Spreads and Funded Accounts
A lot of traders try to become eligible for a funded account using their own trading company.
For traders participating in prop trading contests, spreads will play an exceptionally vital role, since there will be:
- Drawdown caps on daily basis
- Maximum loss restrictions
- Target profit amounts
If the spreads are too wide, then they may lead to:
- Early stops being triggered
- Reward/risk ratios becoming poor
- Lack of consistency
Therefore, good funded traders pick:
- Brokers with tight spreads
- Pairs with high liquidity
- Right time to trade
Common Mistakes Beginners Make When Trading Spreads
Neglecting Costs of Trading
Beginners tend to overlook costs associated with trading because they pay attention only to strategies.
Trading Foreign Currency Pairs
Exotic currency pairs usually have very wide spreads.
Trading in Times of Volatility
Placing trades during periods of volatility will result in big spreads.
Placing Small Stop Losses
A stop loss may get triggered instantly if the spreads widen drastically.
Conclusion
Discovering the meaning of spread in trading is among the first things that every beginner trader must know before he/she enters the market. The spread is the price of trading and will significantly influence your gains, losses, and trading skills.
By learning about spreads, you will be able to:
- Determine favorable times to trade
- Pick appropriate currency pairs
- Decrease trading expenses
- Manage risks better
Such information becomes especially useful when trading using a funded account since consistency and discipline are required for achieving success.
Remember that good trading is not just about making profitable trades but also keeping expenses low, minimizing risks, and understanding the market thoroughly.