In a nutshell:
Forex trading agents/companies will give you two price quotes for every currency pair: the bid and the ask price.
The “bid” refers to the price at which you will be able to SELL the base currency.
The “ask” refers to the price at which you will be able to BUY the base currency.
The gap or the price difference between the bid and ask is known as the spread or as is typically referred to as the bid/ask spread
Consider the spread as the fee for allowing you to make quick transactions. Thus, transaction cost and bid-ask spread could often be used interchangeably. Rather than asking investors for a fee separately each time they carry out a trade, this cost is weaved within the buy and sell price of the currency pairs you trade.
As a business that a cfd trading company is, it is all very logical. After all, they do need to make money from the service they provide.
• They earn by selling the currency to the traders at a higher price than what they actually paid.
• Another way they make money is by purchasing the currency from you at a lesser rate than what they will get for selling the currency.
• The price difference in this case is known as the spread.
Spread in Forex
In forex trading, spread refers to the price difference between the bid and ask rates of a currency pair. Typically, a currency pair will always have two prices: the bid and ask. The bid price refers to the rate at which the base currency is sold whereas the ask refers to the price for which you purchase the base currency.
The base currency is depicted on a currency pair’s left while the variable, quote or counter currency is shown on the right. The pairing shows how much of the variable currency will be needed to buy a single unit of the base currency. The buy price that one quotes will be much higher than the sell price quote and the underlying market rate will be in-between the two.
Typically for a large chunk of currency pairs, trading is done without any commission. However, the spread refers to a cost that gets applied to every trade you place. Instead of charging a commission, most leveraged trading providers will include the spread in the cost of the trading transaction. They tend to take into consideration the higher ask price in relation to the bid rate. The spread’s size could be affected by a number of factors like the pairs you’re trading, its volatility, how big is the trade size and your service provider.
Forex trading pip spread
Pips are used to measure spreads. Spread is a rather small measurement unit for a currency pair’s prices and the last decimal point on the price quote equals 0.0001. While this is the same for all major currency pairs, the pip is the second decimal point, that is, 0.01 for the Japanese yen.
A wider spread indicates a larger difference in price and thus, liquidity is less while volatility is more. A lower spread is an indicator of low volatility and high liquidity. Hence, you have to incur a low spread cost when you trade a currency pair that has a tight spread. When you trade forex, the spread could be variable or fixed. In the case of forex pairs, the spread is variable, and hence any change in the bid and ask price of the currency pair indicates a change in the spread.
How currencies are quoted
Currencies are typically quoted in pairs of two like say the U.S. dollar and the Canadian dollar (USD/CAD). The currency that comes first in this pair is called the base currency, and the currency which follows is known as counter or quote currency (base/quote).
To illustrate this with an example, say you have $1.2500 (Canadian dollars) with which you want to buy $1 (U.S. dollar), the expression USD/CAD would look like: 1.2500/1 or 1.2500. The USD here will be the base currency while the CAD that follows will be a quote or counter currency.
Calculating spread in Forex
After we’ve understood how one quotes currencies in the marketplace, it is important to understand how the spread is calculated. Note that forex quotes always come with bid and ask prices. See more here on Wikipedia
The bid indicates the price point at which a market maker in the forex market agrees to buy the base currency like USD tio exchange with a counter currency such as CAD. On the other hand, ask price refers to the price at which the forex agent is comfortable selling the base currency for counter currency in return.
To reiterate, the bid-ask spread refers to the difference in the rate at which a forex market agent/ trading company purchases and sells a currency. Thus, when a customer begins to initiate a sell trade, the trading agent will quote a bid price and when a customer initiates a buy trade, the agent will quote an ask price.
For instance, if an investor from the U.S wishes to hold a long-term position or purchase euros, the bid-ask price on the trading website is $1.1200/1.1250. Thus, to be able to initiate a trade, the investor will be asked for an ask price of $1.1250. When the investor sells the euros back to the trading agent, the position will change and if the exchange rate does not fluctuate then the investor will be able to get the bid price of $1.1200 for each Euro.
Factors influencing Forex spread
Factors that can have a major impact on the forex spread are:
- Market volatility: Leads to fluctuation
- Major economic factors: The currency pair can be strengthened or weakened
It helps to keep track of the FX economic calendar so you have a better idea of when the spreads could get wider. You will find it helpful to stay ahead of the events that can make currency pairs less liquid since then you will be able to assess when the market could get volatile. Fundamental factors can also affect the liquidity of the market. See our forex trading Youtube videos.https://www.youtube.com/channel/UCOuXB1h-z53g3RHcnAHhVbA
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