Trading in the financial markets can seem confusing for beginners, especially when traders use terms like leverage, pips, lots, and spreads. One of the most important concepts every beginner should understand is the spread. Whether you trade forex, stocks, commodities, or indices, the spread directly affects your profits and losses. Understanding how spreads work can help traders improve their strategies, reduce costs, and protect their capital.
In this guide, you will learn what is spread in trading, how spreads work, the different types of spreads, and why they matter for traders using a funded account.
What Is the Spread in Trading?
The first question that every newbie asks is what is the spread in trading?
The spread is the difference between the price of buying (ask price) and the price of selling (bid price) a tradeable asset. The spread is used by brokers as a means of earning profits from the market.
For instance:
- EUR/USD Buying Price (Ask Price) = 1.1052
- EUR/USD Selling Price (Bid Price) = 1.1050
The difference between the two prices is 2 pips. These 2 pips represent the spread.
text{Spread} = text{Ask Price} – text{Bid Price}
When traders enter into any trade, they are in losses right from the outset because of the spread. The market will have to move in the trader’s favor for profits.
How Spreads Work in Trading
In order for traders to be able to understand the concept of spreads, it is important that they learn about how the buy price and the sell price function.
There are two prices available in the market:
- Bid price – the price that traders can sell
- Ask price – the price that traders can buy
The spread is nothing but the difference between these two prices.
For instance:
- Bid price = 1.2000
- Ask price = 1.2003
- Spread = 1.2003 – 1.2000
- Spread = 0.0003
This is equivalent to 3 pips in forex.
If a trader buys at 1.2003, the transaction will have an initial loss since he will only be able to sell at 1.2000.
Spreads, therefore, are trading costs.
Reasons for Broker Spreads
A broker allows investors to trade in financial markets, and a spread is one of the tools through which brokers generate income. Rather than taking commission, most brokers charge for their services within the spread.
Two types of brokers are available:
1. Fixed Spread Brokers
Fixed spread brokers give you spreads that stay constant under ordinary market circumstances.
Advantages:
- Consistent trading expenses
- Recommended for novice traders
- Easy risk management
Disadvantages:
- Higher spreads
- Not ideal for scalpers
2. Variable Spread Brokers
Variable spread brokers give you variable spreads based on volatility and market liquidity.
Advantages:
- Low spreads during calm periods
- Suitable for aggressive traders
Disadvantages:
- Increased spreads during market news announcements
- Inconsistent trading expenses
It is vital to select the appropriate broker, particularly when trading with a sponsored account.
Factors Affecting Spreads
Spreads do not remain constant. There are various market conditions that influence the widening or tightening of spreads.
Market Liquidity
Popular currency pairs such as EUR/USD experience small spreads since they are frequently bought and sold in the market.
Unpopular assets tend to experience wide spreads.
Market Volatility
The occurrence of news events triggers the widening of spreads due to fast price fluctuations.
Examples are:
- Interest rate decisions
- Employment statistics
- Inflation reports
Market Sessions
Wide spreads are likely to occur during periods when there is no activity in the market, such as:
- London Session
- New York Session
Brokers
Various brokers offer varied spreads depending on their structure. For instance, ECN brokers have tight spreads but charge commissions.
Why Do Spreads Matter to Traders?
The significance of spreads may be overlooked by many beginners; yet, the cost of spreads can greatly affect the profitability of trading in the long term.
How Spreads Influence Profitability
In case a trader makes many trades every day, spreads can become very expensive due to their repetitive nature.
For instance:
- 10 trades per day
- 2 pips per trade
- 20 pips per day in spreads alone.
Spreads Make Scalping More Difficult
Scalpers strive for making money from small differences in price. The larger the spread, the more problematic it becomes since the trader needs to cover both the price difference and spread size.
Spreads Determine the Amount of Risk
A bigger spread means a trader will have to trade at further prices in order to reach their profit target, which should be considered in risk management.
Spreads Are Important When Using a Funded Account
When a trader uses a funded account, they must follow certain restrictions:
- Daily drawdown limits
- Maximum losses limits
- Profit targets
Thus, higher spreads may make passing such conditions more complicated.
Tight Spreads Versus Wide Spreads
Knowing the distinction between tight and wide spreads can help traders select favorable market circumstances.
Tight Spreads
Wide Spreads
- Low transaction fees
- High transaction fees
- Ideal for scalping
- Risky for short-term trades
- Prevalent in major currency pairs
- Prevalent in exotic currency pairs
- Prevalent in busy market hours
- Prevalent in periods of low liquidity
Many professional traders opt for tighter spreads as they incur fewer expenses.
Calculating the Cost of Spread
Spreads are determined by:
- Amount traded
- Currency pair
- Value of pip
For example:
- Spread = 2 pips
- Amount traded = 1 lot
- Value of pip = $10
Cost of spread:
- 2 times 10 = 20
- The investor pays $20 to open a position.
Top Tips for Spread Control
Trade in Liquid Time Periods
The best time period to trade is during liquid hours since the spreads are generally lower.
Do Not Trade in News Releases
Big news releases usually lead to abrupt widening of the spreads.
Select Major Currency Pairs
Currency pairs such as:
- EUR/USD
- GBP/USD
- USD/JPY
generally provide lower spreads than exotic currency pairs.
Work with a Reputable Broker
Using a reputable broker with low spreads will help you earn more in the long run.
Test the Spreads in a Demo Account
Test the spreads offered by your broker using a demo account first.
Common Beginner Errors Related to Spreads
Neglecting Trading Expenses
The majority of beginners think only about the profit without paying attention to the effect of the spreads.
Trade in Exotic Pairs
Spreads in exotic pairs can be quite large and risky for traders.
Over-trading
The more you trade, the higher is the total cost of the spreads.
Trade When Liquidity Is Low
Liquidity is minimal when trading late at night or during holidays, hence resulting in bigger spreads.
Approach of Professionals to Trading Spreads
Professional traders never forget to take into account trading spreads while creating their trading strategy.
In particular, professional traders always:
- Deal at times when trading volumes are the highest
- Make minimum number of deals
- Implement appropriate risk management strategy
- Choose the brokers offering the lowest spreads
- Trade with those setups that are likely to bring gains
Professional traders know for sure that minimization of the costs is as important as making profitable trades.
Conclusion
Understanding what is spread in trading is of paramount importance for all beginners joining financial markets. Spread is the difference between the price at which an asset is bought and the price at which an asset is sold; in essence, the spread is a trading cost. Despite its seeming insignificance, the spread is quite an important factor in traders' success and profitability.
Knowledge of how trading spreads function allows making the best decision regarding deal timings, choice of assets, risk management approach, etc., as well as making traders able to trade effectively with funded accounts.