Bid and ask rates play an important role in all types of financial marketplaces. Below, we’ve defined what these two terms mean and how they relate to forex trading.
Bid and Ask Basics
In trading, the bid is the highest price that the buyer is willing to pay for an asset. The ask, sometimes called the offer, is the lowest price that the seller is willing to take for the asset in question. The ask is typically higher than the bid price, and the difference between the two numbers is known as the spread. As a general rule, the narrower the spread, the more stable (and therefore more liquid) the asset is considered to be.
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 the Spread in Forex
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’re used to thinking of an exchange as a reciprocal transaction, that definition is somewhat misleading when it comes to currency. Like any other good, 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.
Although the exchange rate is influenced by global market conditions, it is ultimately dictated by the bank, broker, or other 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.
Calculating the Spread
Understanding how to calculate the spread can come in handy beyond forex trading. For example, when you travel abroad, it pays to know how much of a spread a hotel or airport kiosk is offering before choosing a host to handle your currency exchange.
Imagine that you’re looking to exchange USD for EUR. Your hotel offers an exchange rate of EUR 1 = USD 1.4 (bid)/USD 1.5 (ask). In other words, its asking price is USD 1.5 per euro. If you wanted to buy €1,000, therefore, you’d need to pay $1,500 (1,000 x 1.5).
Now imagine that you wanted to sell those same €1,000 back to the hotel in exchange for USD. 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 our 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.
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.