In this comprehensive article, we will delve into the world of forex spread trading techniques and explore essential tips that traders should follow to protect themselves against widening spreads. We will cover the concept of forex spreads, the factors that can cause spreads to widen or narrow, and the crucial role spreads play in the cost of trading.

Understanding the Forex Spread

The forex spread refers to the difference between the bid (buy) and ask (sell) price of a currency pair. It is an essential component to consider while trading forex as it determines the primary cost involved. The spread can fluctuate, either widening or narrowing, depending on a variety of factors that we will soon explore in more detail.

Importance of Being Aware of the Spread

Traders must always be mindful of the spread as it directly impacts their trading expenses. A wider spread translates into a larger trading cost, reducing potential profits. Understanding the spread and its implications is vital to successful forex trading.

For novice traders, it is particularly crucial to be cautious of spread widening. If you have a small account size and take a position that is relatively large in relation to your account, the spread could significantly widen, potentially leading to a margin call or forced position closure.

Factors Affecting the Size of the Spread

To minimize the costs associated with widening spreads, it is essential to be aware of the various factors that can influence spread size. These include:

  • Volatility: Volatility in the market, driven by economic data releases or breaking news events, can trigger spreads to widen.
  • Liquidity: A lack of liquidity in the market can also cause spreads to widen. Liquidity and volatility are interconnected, and illiquid currency pairs, such as emerging market currencies, tend to have higher spreads.
  • Spreads and the news: Prior to significant news events such as the NFP employment number release, liquidity providers may widen spreads to compensate for the increased risk associated with the event.
See also  Exploring Short Selling in Forex: An In-Depth Guide to Currency Short Selling

While spreads may temporarily widen, they typically revert to their mean after a few minutes. Therefore, it is advisable for traders to practice patience and execute trades when the spread narrows.

Choosing High Liquidity Forex Pairs

Another spread trading strategy widely adopted by traders, particularly beginners, is selecting high liquidity forex pairs. Major currency pairs, such as EUR/USD (Euro Dollar), USD/JPY (Dollar Yen), GBP/USD (Pound Dollar), and USD/CHF (Dollar Swiss Franc), generally have lower spreads due to their high trading volumes.

However, it is important to note that even major currency pairs are not immune to volatility, liquidity, and news-driven spread widening. Therefore, it is advisable to trade these pairs with moderate leverage or no leverage at all to mitigate potential spread-related risks.

On the other hand, emerging market currencies like USD/MXN (US dollar/Mexican Peso), USD/ZAR (US Dollar/South African Rand), or USD/RUB (US Dollar/Russian Ruble) usually have higher spreads compared to major currency pairs. Therefore, it is prudent to exercise caution and trade these pairs with minimal leverage or no leverage.

In the image below, we can visually compare spreads of different currencies. Major market currency pairs such as USD/JPY and EUR/USD display narrow spreads of 0.7 pips and 0.6 pips, respectively. In contrast, emerging market currencies like USD/ZAR and USD/RUB have much wider spreads of 90 pips and 1000 pips, respectively.

Time of Day Trading

The time of day significantly influences forex spreads, making it beneficial to consider when planning trades. During the major market trading sessions, including London, New York, Sydney, and Tokyo, forex spreads are typically lowest due to the high trading volume.

See also  Driving Factors Behind Gold Price in Trading

Major market currency pairs spread vs emerging market currency pairs spread

Traders can leverage these sessions to their advantage by taking advantage of narrower spreads. Notably, when the London and New York sessions overlap, spreads can become even narrower, presenting favorable trading conditions.

It is important to note that the hours mentioned below are in Eastern Time:

Between 8 am and 11 pm Eastern Time, the London and New York sessions overlap, resulting in increased liquidity and narrower spreads. However, other factors can also influence the best time of day to trade forex, and traders should consider these additional determining factors.

Forex market trading hours

Forex Spread Trading Example Using USD/JPY

Let’s consider a practical example using the USD/JPY currency pair, which falls into the major currency pair category, characterized by high liquidity and consequently low spreads compared to other forex pairs.

To execute successful trades, we must pay attention to factors that could potentially impact the spread. This includes keeping abreast of relevant news and using an economic calendar to stay informed. Economic events with high impact, such as GDP releases, CPI (inflation data), and NFP (non-farm payrolls), can significantly increase volatility and subsequently widen spreads. Therefore, unless actively trading news events, it is advisable to trade around these occurrences.

Another aspect to consider when trading USD/JPY is the time of day. The USD/JPY pair exhibits heightened volatility during the London and New York sessions. These are the most liquid times to trade forex in general, especially during the overlap of these sessions.

Similarly, emerging market currencies have specific main market hours when they are most liquid, and traders interested in these pairs should plan their trades accordingly.

See also  Understanding Quantitative Easing: A Powerful Tool Employed by Central Banks for Economic Expansion

economic data from an economic calendar

Further Resources to Support Your Forex Trading Knowledge

For beginners in forex trading, we highly recommend downloading our comprehensive “Forex for Beginners” trading guide, which provides a solid foundation in the basics of forex trading. It equips traders with essential knowledge, covering topics such as terminology, trading strategies, risk management, and more.

Additionally, you can register for our free live trading webinars, covering a wide range of subjects related to the forex market. These webinars provide valuable insights into central bank movements, currency news, technical chart patterns, and other relevant topics that can enhance your trading knowledge and skills.

Forex market trading hours, London and new York overlap

By utilizing the resources and information mentioned above, traders can navigate the world of forex spread trading with greater confidence and competence, ultimately improving their chances of success.