Forex Spreads: Breaking Down Bid and Ask Rates.
Bid and ask rates play an important role in all types of financial marketplaces. Let’s take a look at what these terms mean and how they relate to forex spreads and trading.
Bid and Ask Rate Basics.
When it comes to trading, the bid is the highest price that a buyer is willing to pay for a certain asset. The ask, also known as the offer, is the lowest price that the seller is willing to accept for a specific asset. The ask is typically higher than the bid price, and the difference between the two numbers is called the spread. As a general rule, the narrower the spread, the more stable (and more liquid) the asset.
In order to trade in global financial marketplaces, a trader must use a broker, a bank, or another large financial institution to host the transaction. In this context, the spread represents the cost of executing a trade.
Understanding Forex Spreads.
In forex, the spread refers to the difference between the bid and ask price for a given currency—also known as the exchange rate. Although we typically think of an exchange as a reciprocal transaction, that definition is somewhat misleading when it comes to currency. Like any other commodity, currency must be bought and sold for a specific price. The process of exchanging one type of currency for another actually involves two separate transactions: the sale of one currency and the purchase of another.
While the exchange rate may be influenced by global market conditions, it is ultimately dictated by the bank, broker, or financial institution hosting the trade. The host is known as the “market maker” because they control the price (and therefore, liquidity) of the asset in question. Currency spreads can vary between brokers and other hosting institutions.
What are the types of forex spreads?
In trading, there are two types of forex spreads: fixed and variable. A variable (floating spread) is a value that continuously fluctuates between the ask and bid prices due to ever-changing factors such as trading activity, supply, shortages, and economic demand.
Meanwhile, fixed forex spreads give market participants the ability to identify the spread cost before buying, allowing them to determine short-term or long-term strategies. This offers more price transparency and a more accurate cost assessment.
How do factors such as market volatility and time of day impact forex spreads?
If there’s a wide spread—a vast difference between bid and ask prices—this typically means there’s high volatility and low liquidity. A large spread occurs when the market has a low trade volume and less activity than usual.
Conversely, a low spread likely means there’s high liquidity and low volatility, which occurs when the market is active and there’s a lot of activity or a high number of contracts that are being traded.
The time of day will also impact forex spreads. In the U.S., European trading kicks off as early as 3 a.m. EST, while the Asian markets are still operating late at night for European and U.S. traders. That means that if a European trade is initiated during Asian market trading hours, the forex spread will be much higher than if it took place during the European session.
If it’s not the normal trading session for a specific currency, there will be fewer traders involved in trading that currency, reducing overall liquidity.
What’s considered a high spread?
When there’s a large gap between the bid and ask price, a spread is considered high. A spread that’s higher than normal typically means that the current market is volatile or that there’s low liquidity caused by trading outside of market hours.
How to Calculate the Spread.
Understanding how to calculate the spread is a helpful skill with benefits that go beyond forex trading. For example, when you travel abroad, it pays to understand the spread offered by a hotel or airport kiosk before choosing a host to handle your currency exchange.
Imagine that you’re looking to exchange U.S. dollars for euros. Your hotel offers an exchange rate of EUR 1 = USD 1.4 (bid)/USD 1.5 (ask). In other words, its asking price is $1.5 per euro. Therefore, if you wanted to buy €1,000, you would need to pay $1,500 (1,000 x 1.5).
Later, you may want to sell the €1,000 back to the hotel in exchange for U.S. dollars. This time, you would sell the hotel euros at the bid price of USD 1.4 and receive $1,400 in return. The difference of $100 that was lost in the two transactions is the spread, which is pocketed by the market maker (in this case, the hotel). By keeping its ask price slightly higher than the bid price, it’s able to make a small profit on every transaction it hosts. This same general principle is true when it comes to buying and selling currency on the foreign exchange market.
In this example, the hotel is likely relying on another financial institution—such as an international bank—to host the transaction, making it the second market maker involved in this exchange. As a result, the spread it offers to its customers will be much higher than the market price in order for it to cover its costs and mitigate risk.
Currency Quotes: Direct vs. Indirect.
Within forex, the price of a currency pair can be expressed in one of two ways: as a direct or an indirect price quote.
A direct price quote expresses the price of a foreign currency in terms of the domestic currency in your possession. For example, if your domestic currency is USD, a direct quote for USD to GBP might be 1.1430. Because USD is the base currency, it would be expressed first (as a ratio of USD/GBP). This quote indicates that USD 1 = GBP 1.1430, with the base currency (USD) taking priority.
Indirect price quotes are the exact opposite. They express the foreign currency value per one unit of your domestic currency. Rather than expressing USD/GBP, for example, an indirect quote would express GBP/USD. The same direct price quote provided above could be turned into an indirect price quote of 0.8748, indicating that GBP 1 = USD 0.8748, or roughly 87 cents.
In forex, USD is typically used as a base currency, with direct price quotes reflecting the value of USD/foreign currency. Recognizing what type of quote you’re being given and understanding how to convert a direct quote into an indirect quote—and vice versa—will help you determine the spread and compare your options.
Ready to Get Started?
Now that you’ve learned about forex spreads and bid and ask rates, delve deeper into trading by opening a live account with Valutrades today!
Disclaimer:
The information provided herein is for general informational and educational purposes only. It is not intended and should not be construed to constitute advice. If such information is acted upon by you then this should be solely at your discretion and Valutrades will not be held accountable in any way.
This post was written by Graeme Watkins.
CEO Valutrades Limited, Graeme Watkins is an FX and CFD market veteran with more than 10 years experience. Key roles include management, senior systems and controls, sales, project management and operations. Graeme has help significant roles for both brokerages and technology platforms.