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- How the Forex Spread is Calculated
How the Forex Spread is Calculated
The OANDA Spread Cost Calculator is based on some simple math, using the following factors:
| Factor | Our assumption (for running example) |
|---|---|
| Deals per day | 5 |
| Trades per deal | 2 (a deal consists of in and out trades) |
| Trading days per year | 250 |
| Leverage | 2 (this is a conservative estimate) |
| Account equity | $1 million |
Step 1: Multiplying these five factors gives the annual trading volume:
5 x 2 x 250 x 2 x $1 million = $5 billion
Step 2: Calculate the absolute spread cost (the total spread paid to the broker over the course of a year, expressed in account currency):
Note that if the quote currency of the pairs traded is different from the currency of the account, then spread costs would have to be converted from the quote currency to the account currency.
For example, with an annual trading volume of $5 billion and a spread of 3 pips, the absolute spread cost is $5 billion x .0003 / 2 or $750,000.
Step 3: Calculate the relative spread cost (the total amount of spread paid over the course of a year as a percent of account equity):
Step 4: Calculate the potential expected profitability when switching to a broker who offers a lower spread (in this example, from 3 pips to 2):
Return with current spread + relative spread cost (current spread)
Return with current spread - relative spread cost (new spread)
Assuming a current annual return of 20%, and a move from a broker offering a 3-pip spread to one offering a 2-pip spread, on average, your return would increase from 20% of account equity to 45%: (20% + 75 % - 50% = 45%), a 125% increase. By reducing the spread by one third, profitability would more than double.
Note that compounding is not taken into account in these calculations.