Spread trading is the primary cost of trading between currencies and as such, it is important that new traders understand the place of spread in fx trades. In this article, we will deal with the following
- Definition of a spread
- The basics of a spread
- Interpreting a spread
DEFINITION OF A SPREAD
Spreads are defined as the price difference between the bid and ask prices. In fx, a bid is defined as the maximum price a buyer is willing to pay for a security; while the asking price is simply the maximum price at which a trader is willing to purchase a particular security. So, the difference between these two prices, the bid price and the asking price, is defined as a spread.
THE BASICS OF A SPREAD
To understand the basics of a spread, there is the need to know what a spread is and how to calculate a spread. The spread comes into play in every trade because it is rare to carry out a transaction where the bid price and the asking price are exactly the same, there is always a spread.
Here is how to calculate a spread:
Basically, fx prices are quoted in four decimal places, that is, five digits with a decimal point after the first digit. Let us take the Euro/US dollar for example.
The buy price = 1.35356
And the selling price = 1.35326
The spread, in this case, is gotten by finding the difference between the buy price and the selling price
The spread = 1.35356 – 1.35326
The spread = 0.0003
Basically, the spread of the transaction is 0.0003.
The percentage in point stands for Point in Percentage. It is simply a point for calculating profits and losses in a trade. The percentage of point value is the fourth digit after the decimal point. In this case, the percentage of point value is 3 percentage in point.
INTERPRETATION OF SPREAD
The spread, as expressed above, are in numbers. What exactly are those numbers? What do they represent? How are they related to actual money (in this case dollar and cents)?
To understand spreads and interpret them correctly, you have to, first of all, know how to find the spread in percentage in points. If you can do that, then interpreting spreads in actual money is very simple. All that need to be done is to multiply the spread in percentage in point and percentage in point cost per lot, and then divide it with the spread cost. If you are trading a lot of a lot size of 10,000 base units, then 1 percentage in point is equal to 10,000 lots.
That is [3 (spread in percentage in point) x $1 (percentage in point cost per 10,000 lots)] ÷ $3 (spread cost)
After calculating this, one can tell in monetary terms, how much profit or loss has been incurred in the transaction depending on the direction of the market.