All Forex quotes display two prices, the bid and the ask.
TAKEAWAYS
- Getting a fill on your options order is often a tradeoff between price and speed
- Your order is more likely to get filled when it’s at the natural price — the ask price (for buyers) or the bid price (for sellers)
- The mark price – halfway between the bid and the ask – might offer you a better price, but your order may not be filled as quickly
Understanding Exchange Rates in Forex Trading
For the most part, exchange rates are based on supply and demand in the global financial market. In other cases, exchange rates might be fixed or pegged to the value of another country’s currency. They tell you how much your currency is worth in a separate currency. Forex traders might also monitor the spreads to determine broader liquidity conditions in currency markets.
At first, it might appear confusing, but once you regularly trade forex, it becomes second nature.
For example, if you are thinking about trading USD/CHF, this is the Swiss franc-to-dollar exchange rate. The currency on the left is the base currency, while the currency on the right is the quote currency. If the USD/CHF exchange rate is 1.5, this means one Swiss franc will purchase $1.50. Should the exchange rate climb, this signifies that the base currency has surged in value and vice versa.
What is a Spread?
A spread is a conventional concept for financial markets. It simply represents the difference between the price at which a trader may purchase or sell an underlying asset.
You had experienced spread already when you came to a bank or an exchange office to get foreign currency. The bank always shows two quotes of currency – the one at which it agrees to buy it from you and the one at which it is ready to sell it to you. The spread between these two prices forms the bank’s revenue from the foreign exchange operations it performs for you.
Every asset has a Bid and Ask price; about them in the next paragraph. When you Buy an asset, FBS opens your order at an Ask price, and vice versa; when you Sell an asset, FBS opens your order at a Bid price. You can think about forex Bid-Ask spread as a fee for performing a trade. Smaller spreads mean better conditions for traders.
How Does Bid-Ask Spread Work?
There are two counterparts in financial markets, buyers and sellers. Buyers want to buy an asset at the lowest price possible. On the contrary, sellers want to sell an asset at the highest price. These two sides create a buying price called Bid and a selling price called Ask.
Spread is the difference between Bid and Ask prices, so the Bid-Ask spread formula looks like this: Ask – Bid = Spread.
To sum up:
- The price we pay to buy the pair is called Ask. It is always slightly above the market price.
- The price at which we sell the pair on Forex is called Bid. It is always slightly below the market price.
- The price we see on the chart is always a Bid price.
- The Ask price is always higher than the Bid price by a few points.
- Spread is the difference between these two prices.
SPREAD = ASK – BID
For example, the EUR/USD Bid/Ask currency rates are 1.12502/1.12506. You will buy the pair at the higher Ask price of 1.12506 and sell it at the lower Bid price of 1.12502. This represents a spread of 4 points.
Do you buy at the bid or ask?
Assets are always bought at the bid price. The term bid and buy in this context are interchangeable, so often the bid price will simply be called the buy price. Similarly, the ask price is the same as the sell price.
If you want to long a market, this means taking up a buy position. You will open the buy position at the bid price. By going long on a market, you are hoping its price rises and you can close out the position at the ask price for a profit. Alternatively, if you are shorting a market, you will open the position at the ask price and close it at the bid price.
Types of spread
The types of spread depend on the policy of the broker. A spread can be fixed or floating.
Fixed spreads
Fixed spreads remain the same no matter what market conditions are at any given time. This way, you know for certain how much you will pay for a trade. Another good thing is that the broker won’t be able to widen the spread even if the market conditions change.
Floating spreads
Floating or variable spreads, on the contrary, are constantly changing. They will widen or tighten based on the supply and demand of currencies and the overall market volatility. Floating spreads usually increase during important economic releases and bank holidays when the amount of liquidity in the market declines. However, when the market is calm, they can be lower than the fixed ones.
How to choose the optimal spread
The best thing you can do with your trading is to seek a broker with a low spread, as it’s the main gauge of fees you will pay for your trading activity. FBS provides amazing spreads for the most popular trading pairs, making it easy for you to trade without worries.
The optimal type of spread depends on your preferences as a trader. In general, traders with smaller accounts who trade less frequently will benefit from fixed spread pricing. Traders with larger accounts who trade frequently during peak market hours (when spreads are the tightest) and want fast trade execution will benefit from variable spreads.
Notice that FBS offers trading accounts with fixed and floating spread, so you can choose the option you like best or have several different accounts.
Calculating costs
Note that the cost of spread on Forex is usually negligible in comparison with the expenses on the stock or options markets. As spread is quoted in points, a trader can easily calculate the cost of every trade by multiplying the spread in points by the value of 1 point. How to calculate profit?
Spread is an important parameter to consider when you choose a broker. Make sure that you are comfortable with the offered spreads. Notice that you can always test the company’s trading conditions without investing your money by opening a demo account.
The shorter the periods of your trade, the more important is the size of a spread. For instance, if you hold a position open for several minutes and your gain is 10 points, a 3-point spread would mean that you pay 30% of your profit for the execution of this trade. If you keep your trade open for a day, there will likely be a bigger change in the price – let’s say you would earn 100 points. In this case, you will pay only 3% of your profit as a spread.
More popular currency pairs have smaller spreads. For example, the spread for EUR/USD trading is usually very small or, as traders say, tight.
What Causes a Bid-Ask Spread to Be High?
Sometimes, floating spreads can get very wide due to market fluctuations like important economic releases, news, or so-called Black Swans (unexpected and greatly powerful events that may cause vast movements). As time goes on, the spread tends to return to its normal state.
Notice that exotic instruments may have high spreads, too. For example, USDTRY (US dollar to Turkish Lira) is an exotic instrument, thus having a bigger-than-usual spread.
Finally, spreads widen when there is less liquidity on the market due to bank holidays.
Conclusion
The spread is a fee that traders pay to their broker for the opportunity to trade on the currency market. It represents the difference in the price at which a trader purchases or sells an underlying asset.
Spreads can be fixed or floating and the best type of spread depends on the preferences of the trader. If you trade more frequently, you are going to love tight spreads. Choosing a broker with low spreads is recommended to minimize the costs associated with trading and maximize the result.
Additionally, it’s important to note that the spread is often quoted in points which are the smallest unit of price movement in forex. It is crucial for traders to understand the concept of spread and the different types of spreads offered by brokers to make informed trading decisions and manage their costs effectively.
