Forex Spreads: How Bid And Ask Rates Work
The forex market is driven by the forces of demand and supply. That’s why forex trading spreads vary depending on the time of day, the currency pair in question, and various economic conditions.
In this article, we will be diving deeper to describe the role that the Bid and Ask rates play in the forex markets and how to calculate the impact of forex spreads on your trades.
Basics of Bid and Ask Rates
An Ask is the lowest price you (the buyer) can pay for forex trade. A Bid is the highest price you can fetch for an asset that you hold and want to sell. The spread is the difference between the Ask and Bid prices.
In the euro vs US dollar chart above, the average Bid price for the EUR/USD is 1.0933, while the prevailing Ask price is 1.0935, which equates to a spread of about 1.9 pips.
If you are opening a long position on the currency pair (buying), then you will be quoted the Ask price, whereas, if you are opening a short position (selling) you will be quoted the Bid price.
Global financial markets require traders to use brokers, banks, or other large financial institutions to host their transactions. Spreads represent a trade’s execution cost.
What Are Spreads In Forex Trading?
Spreads in forex are determined by the difference between the bid and ask price of a currency.
While we normally think of the exchange as a reciprocal transaction, this definition is somewhat misleading in the case of currencies. In the same way that any other commodity is bought and sold for a specific price, the currency is no different.
So, exactly what do spreads mean in forex and who determines them? When one currency is sold and another is purchased, the exchange process involves two separate transactions.
Banks, brokers, and financial institutions ultimately determine the exchange rate, even if global market conditions have a significant influence. Because the host controls the price of the asset (and therefore, its liquidity), they are known as the “market maker.”
However, dealing desk brokers and other hosting businesses can set different spreads for their currencies.
Therefore, for a dealing desk forex broker low spreads provide them with an opportunity to earn more without affecting their fixed spreads. This is often how they make money to supplement their commission-free services.
What Are The Different Types Of Forex Spreads?
Forex spreads can be fixed or variable. Due to constantly changing factors such as trading activity, supply, and shortages, a variable (floating spread) fluctuates between the Ask and Bid prices.
Alternatively, fixed forex spreads let market participants identify the spread cost before buying, which allows them to develop short-term or long-term strategies. As a result, prices are more transparent and cost assessments are more accurate.
What Is The Impact Of Market Volatility And Time Of Day On Forex Spreads?
There is usually high volatility and low liquidity if there is a wide spread between the Ask and Bid prices. The spread is large when there is little activity in the market and a low trade volume.
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.
Forex spreads are also affected by the time of day. Trading on European markets begins as early as 3 am EST in the U.S., while trading on Asian markets continues into the night for both European and U.S. traders. The forex spread will be considerably higher for European trades initiated during Asian market hours than for European trades initiated during European trading hours.
A currency’s liquidity will be reduced if it is not in its normal trading session, because fewer traders will be involved.
What Is The Difference Between Tight Spreads And High Spreads?
Just as the words indicate, tight spreads occur when the difference between the Ask and Bid price is very small. On the other hand, high spreads occur when the gap between the two price quotations is large.
Low forex spreads are present during times of high trading activity, which improves liquidity, whereas high spreads are signs of low liquidity in the market.
Another factor that can affect your trading spread is the type of broker you are using. As noted before, some brokers factor in mark-up margins in the spread thereby increasing the difference between the Ask and Bid prices.
In our initial example, we used a Forex.com chart on TradingView. In the example below, we used FXCM.
In our previous example, the EUR/USD currency pair had a spread of 1.9 pips. In the chart above, the spread went down to 0.2 pips just after changing the screen from Forex.com to FXCM.
In the chart above, the NZD/USD currency pair has a spread of 0.7 pips, which is more than three times the EUR/USD spread. This demonstrates a case of less popular/liquid currency pairs having a higher spread.
A Simple Method For Calculating Spreads
Having a good understanding of spreads is a valuable skill that goes beyond forex trading. When you travel abroad, understanding a hotel or airport kiosk’s spread before choosing a host for currency exchange is important.
Consider the scenario of exchanging U.S. dollars for euros. Currently, your hotel’s exchange rate is EUR 1 = USD 1.4 (bid)/USD 1.5 (ask). This means its asking price is $1.5 per euro. In other words, if you wanted to buy €1,000, you would have to pay $1,500 (1,000 x 1.5).
It may be that you will want to return the €1,000 to the hotel in exchange for U.S. dollars later. If you sold the hotel euros at USD 1.4, you would receive $1,400 as a return. In this case, the market maker pockets the $100 difference from the two transactions as a spread (in this instance, the hotel). It makes a small profit on every transaction it hosts because its ask price is slightly higher than the bid price. Foreign exchange markets operate on the same principle when it comes to buying and selling currencies.
As a result of this example, another financial institution-such as an international bank is likely to host the transaction, making it the second party to the trade. To minimize risk and cover costs, it will offer its customers a much higher spread than the market price.
Indirect vs. Direct Currency Quotes
Direct or indirect price quotes can be used to express the price of a currency pair in forex.
In a direct price quote, the foreign currency exchange rate is expressed in terms of the domestic currency you have in your possession. A direct quote for USD to GBP, for example, might be 1.1430 if your domestic currency is USD. Because USD is the base currency, it would be expressed first (as a ratio of USD/GBP). In this quote, USD 1 equals GBP 1.1430, putting the base currency (USD) first.
Compared to direct price quotes, indirect price quotes are the exact opposite. They show the exchange rate between your domestic currency and foreign currency. For example, an indirect quote would express GBP/USD rather than USD/GBP. As an indirect price quote, the same direct price quote above would be 0.8748, which means that GBP 1 would be equal to USD 0.8748, or roughly 87 cents.
Direct price quotes typically reflect USD/foreign currency’s value, with USD serving as the base currency. By understanding how direct quotes can be converted to indirect quotes-and vice versa-you can determine the spread and compare your options more easily.
Forex spreads can have a huge impact on your trading experience. While fixed spreads allow you to predict costs related to spreads, they are not always the best forex spreads. Variable spreads can sometimes be viewed as more exciting because sometimes they can be as low as zero depending on market liquidity.
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