How Spread Size Influences Your Entire Trading Strategy

Spread size is a key factor that can make or break your trading strategy. It directly impacts your profits, transaction costs, and overall approach to trading. Whether you're a day trader making frequent moves or a long-term investor, understanding how low spread fx brokers affect trading decisions is essential.

This article is very intensive on the subject and points in detail how spread size impacts your strategy and what other aspects need to be taken into consideration before trading. Let’s begin.

Understanding Forex Trading

Forex trading is popularly described as the process of exchanging currencies. When, each time a buy or a sell of two associated countries' currencies takes place these two currencies are known in the market as currency pairs most common being the EUR/USD, JPY/USD AND GBP/USD.

There is a distinctive difference between the exchanges that are present in other markets and the forex market because it does not have a physical exchange. The trade would take place even in the absence of the traders. Hence it is an entirely Over-the-counter market. The trade is performed by a network of banks and brokers, through the internet. Since the forex market is an online market, it is always open twenty-four hours a day, seven days a week and therefore does not close for any period due to the fact that trading spans multiple time zones and involves transactions from Europe, Asia, and North America throughout the entire week.

Key Concepts:

• Currency Pair: The two currencies being traded.
• Base Currency: The first currency in the pair.
• Quote Currency: The second currency in the pair.
• Spot Rate: The present value of the exchange rate for two currencies.
• Pip: The smallest change in Forex price movement which is usually about 0.0001 of the currency pair's quotation.
• Liquidity: The capacity of purchasing or selling a currency in the market.
• Liquidity: The ease of buying or selling a currency in the market.

The Spread Explained Beautifully

The term 'spread' signifies a difference in the buy and the sell price for a particular currency pair. This type of expenditure is casually known as trading cost. The term bid is defined as the highest price offered by buyers whereas the ask is defined as the price sellers are asking. The difference between these two prices is further referred to as the bid-ask spread. 

As an example, the bid for EUR/USD is 1.1000 and the ask is 1.1002. That tells us that this pair has a bid/ask spread of 2 pips.

How Spread Size Influences Your Trading Strategy

Impact on Profitability

The degree of profit potential increases with the degree of spread. To make a profit, one must tolerate a larger price movement in his favor as an increase in spread sets in. This is of great relevance particularly in scalping strategies, where almost every concerning strategy aims at making trades with minimal price change. For instance; if a trader enters and exits the market many times within a day, the frequency of trading will lead to higher spread cost.

Risk Management

The measure of the spread plays a crucial role in risk management. An overly high spread on the other hand may render the risk to the win/loss ratio unfit for placing such a trade. It is important for traders to always incorporate the spread in their estimation of gains, losses or both. For example, whereas one can buy EUR/USD at 1.1002 and sell it at 1.1000, the quoted 2-pip spread is already working against the trader immediately.

Order Execution and Timing

Due to high volatility in quick changing markets, the spreads tend to widen. This may either delay the execution of your order or lead to a situation where the order is filled at a different price from the anticipated one, otherwise known as slippage. Market makers may widen the spread during periods of low liquidity or excessive volatility, thus affecting your smooth entry or exit from a trade.

Types of Spreads Traders Encounter

There are different types of spreads you’ll encounter, depending on the broker and market conditions.

Fixed Spreads

One fixed spread does not vary with time making it quite predictable. This is advantageous for retail traders who do not want their trading costs disturbed. However, limited spreads are on the average a bit wider in order to mitigate the risk involved.

Variable (Floating) Spreads

Variable spread is when there is a difference in the bid and ask price with respect to the market at that point in time. Usually, the spreads are tight in a stable market and widen in prices in extreme market conditions. These spreads provide improved conditions in an even and stable market. However, they tend to be very costly and expensive when the market experiences significant changes.

Spread vs Commission

There are some Forex brokers, who provide tighter spreads, however, before each trade a commission is charged. Therefore, the overall expense may be less than carrying out trades with bigger spreads where commission is not charged. Selling and buying spread and commissions should be taken into account as well when determining which brokers are preferable.

Factors That Influence Spread Size

There are various elements that influence the size of the spread, and knowing these aspects contributes to better trading strategy formulation.

Market Liquidity

Liquidity indicates the purchasing or selling activity of an asset, in order not to alter its price significantly. More often than not, higher liquidity entails a narrower spread as a result of a larger pool of buyers and sellers present in the market. In the case of liquid currency pairs such as the euro and dollar, the spreads tend to be narrow since there is a lot of market activity.

Market Volatility

The increased volatility brings along a higher risk that brokers have to bear and this can mean that the spreads can be increased. For example, when some economic events most especially the announcements of central banks or during political instability, these distances can be greatly increased. Hence, retail investors need to be wary and careful accordingly owing to the trading conditions that prevail during such periods.

Economic and Geopolitical Events

Changes in interest rates, elections, or geopolitical events, among others, can result in significant currency price fluctuations making spreads wider than before. As a result, traders have to be aware of certain upcoming events to protect themselves from engaging in unfavorable trades.

Broker Type

Different brokers offer varying spread types. Place the command Market makers generally guarantee fixed spreads but in case of extreme volatility may reset them to higher values. ECN brokers (Electronic Communication Networks) offer variable spreads which are usually much lower, however, these are subject to market changes.

Spread as a Transaction Cost

Spreads act as a built-in transaction cost. Regardless of whether you are earning from the Forex market for only one day or for months, the cost of the spread should be included in potential profit margins.

Impact on Day Trading

Due to the high frequency of trades, for day traders and scalpers even the slightest increase or decrease in the spread size can impact the overall profitability of the traders’ account. For instance, if a trader executes say 20 trades per day and they execute them all carried at the particular price, the trader must also understand the implications of the spread on those trades. In such cases of high-frequency trading, traders’ returns can be swallowed by the spreads within no time.

Long-Term Traders and Spread

Long-term traders, such as those practicing swing trading, may not feel the impact of spread as much. They tend to hold positions for longer, allowing the market to move further in their favor and absorb the spread cost over time.

Comparing Spreads Across Different Brokers

Other brokers may apply more complex pricing strategies in which they charge commission-based fees but offer clearer prices instead.

Tools to Compare Brokers

It's crucial to consider both spread pricing and any hidden fees, such as commissions or deposit/withdrawal charges.

Spread and Technology: The Modern Trader’s Advantage

Technology has significantly reduced spreads in recent years. 

The Role of Online Platforms

Modern platforms provide real-time access to spreads and allow traders to make informed decisions. For example, brokers using Bloomberg’s data feed can offer tight spreads based on accurate, up-to-date information.

Automated Trading Systems

Automated trading systems have become a key tool for managing spread costs. These systems use algorithms to execute trades at the best possible spread, minimizing transaction costs and human error.

Spread Size in Different Market Conditions

The size of the spread varies based on market conditions. Traders need to adapt their strategies to suit different environments.

Low vs High Volatility

During phases of low volatility, for example, we see that spreads are usually tight. However, in extreme market conditions, spreads tend to be wide because of uncertainty in the market. For instance, when a central bank acts and makes any decision regarding the interest rates, the spreads of the currency pairs such as the US dollar and Euro increase dramatically.

Illiquid vs Liquid Markets

Conversely, exotic currency pairs or illiquid markets may have wider spreads, making them more expensive to trade.

How to Minimize Spread Costs in Your Strategy

Timing Your Trades

One alternative to cut down on the costs related to spread is carrying out the transactions during the times with surplus liquidity. As an example, the session where the Europe and North America markets overlap offers the lowest spread most of the time.

Choosing the Right Broker

It’s essential to choose a broker with competitive spreads. Look for brokers that offer tight spreads during normal conditions but also provide transparent pricing during volatility.

Diversifying Your Strategy

The effect of widespread trading ranges can be lessened by splitting traders’ activities among various trades. Implementing different strategies when placing bets, such as short positioning trading and going long on the same underlying asset, reduces the adverse effects of wider spreads on volatility as well.

Conclusion

It is impossible to underestimate the importance of the spread, its elements as well as its contribution in the construction of the whole trading system. Whether you are scalping, swing trading rare long-term positions, knowing the impact of spreads on the profit is crucial for every trader. All these processes will help to describe and elaborate better the future trade strategies.

Keep in mind the economic calendar and the importance of regularly comparing broker analyses. Utilize, for example, the latest devices such as robotic systems, in order to reduce the negative impact of large readjustment spreads.