The Spread

The spread is the difference between the bid price and ask price of a currency pair. Usually long orders are executed at ask price and short orders are executed at bid price. Once a trade is executed, the trader’s position is thrown into debit, according to the financial value of the spread.

There is a lot of information that forex traders may gain from the spread. Some of this information can be used in determining risk, working out risk-reward ratios, understanding how far a currency pair is expected to move for a certain day, as well as understanding what currencies should be traded and which should be avoided.

a)      Large Spread Currencies

There are currency pairs which have very large spreads. This is because the liquidity on these currency pairs are not as high as the commonly traded pairs such as the EURUSD. Examples of currency pairs with large spreads include the pairing of the Swedish and Norwegian Crown with the US Dollar and the Euro (USDNOK, USDSEK, EURNOK and EURSEK) as well as pairings of the Euro and the USD with the South African Rand.

As a rule, currency pairs with large spreads also have large intraday movements. Whereas the EURUSD may be restricted to movements of between 100 pips to 150 pips a day, the exotic currency pairs mentioned above have intraday movements in the range of thousands of pips. However, the value of each pip is not the regular pip value of the liquid currencies. The pip value of the exotic currencies is about 1/10 of the regular pip value of their liquid rivals. So given the large spreads of these exotics, it is important that a trader knows exactly how trading a pair that could have a spread of about 50 pips would affect the account balance. It is not very wise to trade large spread currency pairs with a small account size. Such an account would be unable to handle the large intraday movements that occur as well as the initial spread deficit when the trade is initiated.

b)     Spread in Risk-Reward Calculation

Risk-reward calculation in forex simply means, how much goes into the Stop Loss and the Take Profit setting. Traders are encouraged to aim to make 2 pips for every 1 pip risked in the stop loss as the minimum risk-reward setting. Knowing how much you will pay in spreads is an important part of this calculation, because the spread is added to the risk component of the calculation. If you want to trade a currency with a spread of 10 pips, and you add a 50-pip stop loss, would the asset be able to make at least 120 pips to cover for this risk setting? How about if the spread is at least 40 pips? Would the account size handle this comfortably without being stretched too thin?

  

c)      Intraday Movements

As a rule, currencies with larger spreads have wider intraday ranges. This must be factored in when setting a stop loss or a profit target. If the account size cannot handle trading currencies with large spreads, the trader’s best bet is to avoid such currencies and trade those with lower spreads so as to save cost and trade something more manageable.

Conclusion

We can see from this discussion on the spread that the information it provides may be used in a number of ways within the trade process. Traders should therefore understand these processes and see the spread as a useful information tool and not merely a cost incurred on setting a trade.

This article was written by easy forex. For more articles please visit their website.

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