Home > Terms & Techniques > Bid-Ask and Spreads
What Is The Bid and Ask Rate Telling You?
As is true of any financial market, there is a selling price and a buying price for every commodity. These prices are almost always determined by the market conditions.
The difference that one can see between the bid rate and the ask rate is indicative of the level of liquidity that exists in a certain currency. Some of the major currency pairs traded in the foreign exchange market are Euro-US Dollar (EURUSD), US Dollar-Japanese Yen (USDJPY) and Pound-US Dollar (GBPUSD).
A high liquidity in the currency also means that you can always find a buyer to buy the currency you are selling and a seller who is willing to sell you the currency at the actual market rates.
What is a bid-ask spread?
One also hears of the bid-ask spread which is the difference between the bid price or buying price for the currency and the ask price or selling price for the currency.
In the foreign exchange market as in other financial market, a market maker has to quote both prices at the same time for his customers. In other words, he has to quote a price at which he is willing to buy a certain currency pair (the bid) and he has to quote the price at which he is willing to sell a certain. In many cases, the tight spread that is offered applies only to a capped trade sizes that are very inadequate for most of the common trading strategies.
Spread policies change from broker to broker!
Spread policies change a great deal from broker to broker, and the policies are often difficult to see through. This certainly makes comparing brokers much more difficult. Some brokers actually offer fixed spreads that are guaranteed to remain the same regardless of market liquidity. But since fixed spreads are traditionally higher than average variable spreads, you are paying an insurance premium during most of the trading day so that you can get protection from short-term volatility.
Other brokers offer traders variable spreads depending on market liquidity. Spreads are tighter when there is good market liquidity but they will widen as liquidity dries up. When it comes to choosing between fixed and variable rates, the choice depends on your individual trading pattern. If you trade primarily on news announcements that you hear, you may be better off with fixed spreads. But only if quality of execution is good.
Some brokers have different spreads for different clients based on their accounts. For example; those clients that have larger accounts or those who make larger trades may receive tighter spreads, while the clients that are referred by an introducing broker might receive wider spreads in order to cover the costs of the referral. Some offer the same spreads to everyone.
Problems can come up when you are trying to learn about a company's spread policy because this information, along with information on trade execution and order-book depth is rather difficult to get. Because of this, many traders get caught up in all of the promises they hear, and take a broker's words at face value. This can be dangerous. The only real way to find out is to try out various brokers or talk to those who have.
The spread is how brokers make their money.
Wider spreads will result in a higher asking price and a lower bid price. The consequence to this is that you have to pay more when you buy and get less when you sell, which makes it more difficult to realize a profit.
Brokers generally don't earn the full spread, especially when they hedge client positions.
The spread helps to compensate for the market maker for taking on risk from the time it starts a client trade to when the broker's net exposure is hedged (which could possibly be at a different price).
Spreads affect the return on your trading strategy
Spreads are important because they affect the return on your trading strategy in a big way. As a trader on the forex marketplace, your sole interest is buying low and selling high (like futures and commodities trading). Wider spreads means buying higher and having to sell lower. A half pip lower spread doesn't necessarily sound like much, but it can easily mean the difference between a profitable trading strategy and one that isn't profitable.
The tighter the spread is the better things are going to be for you. However tight spreads are only meaningful when they are paired up with good execution. Quality of execution will decide whether you actually receive tight spreads.
Spreads should always be considered in conjunction with depth of book. Oddly enough, when it comes to economies of scale, forex doesn't even act like most other markets. On the inter-bank market, for example; the larger the ticket size, the larger the spread is.