Bid vs. Ask Price in Forex Trading

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While the word “price” is sometimes used when referring to currency quotes, the more accurate phrase is “exchange rate” because each foreign exchange (forex) currency pair has a base and counter currency that is exchanged for one another when a transaction takes place.  

Stock market operators will generally refer to bid versus ask prices and prefer quotes with a tight ask and bid price spread. Forex traders more commonly talk about bid versus offer exchange rates and look for a broker with tight dealing spreads. 

In general, the bid or lower exchange rate reflects where an online forex broker or Interbank market maker is willing to buy a currency pair. The offer or higher exchange rate indicates where the broker or market maker will sell the currency pair. The combination of these bid versus ask forex rates comprise a two-way quote that reflects the current level of supply and demand for a particular currency pair. 

In this article, Benzinga explains how to read bid and ask (or offer) exchange rate quotes and how they can affect your success as a forex trader. 

What is Bid Price?

The bid exchange rate, or simply the bid, is the highest exchange rate a market maker is willing to pay for a currency pair in the forex market. Because currencies trade in pairs, the counter currency is used to pay for the base currency. A bid will be expressed in the amount of counter currency the market maker will pay for one unit of the base currency. 

In the EU euro versus U.S. dollar (EUR/USD) currency pair, the bid or left side of the quote shows how many U.S. dollars the market maker will pay to buy one euro. The bid rate represents the exchange rate at which the market maker will buy one unit of the base currency (EUR) with the stated amount of counter currency (USD).

For example, a two-way quote for the EUR/USD currency pair might be 1.0777/1.0779. In making this quote, the market maker is showing a bid of 1.0777 U.S. dollars to purchase 1 euro. You will note that the lower bid exchange rate generally appears on the left side of the quote by convention. 

What is Ask Price?

While stock traders might talk about the ask or asking prices, forex traders usually refer to the offer rate or exchange rate. Analogous to the asking price in stocks, an offer rate represents the lowest exchange rate a market maker is willing to accept for selling a currency pair. 

Because currencies trade in pairs in the forex market, the offer rate would also represent the amount of counter currency the market maker will buy to sell one unit of the base currency in a foreign exchange transaction. 

Using the EUR/USD example discussed above, the offer side of the 1.0777/1.0779 two-way dealing quote for the EUR/USD exchange rate appears on the right by convention. This means that the market maker will sell one euro for 1.0779 U.S. dollars. 

Understanding the Bid-Ask Spread in Forex

The difference between the bid and offer exchange rates is known as the dealing spread or the bid-offer spread among forex traders. Dealing spreads vary considerably between different currency pairs in part because of differing liquidity levels and the value of one price interest point (pip). Dealing spreads are the main source of income for many online forex brokers. 

Keep in mind that a wider dealing spread makes it more costly for a forex trader to regularly cross the spread by trading in and out of the market.  This motivates many active forex traders who use scalping and other short-term strategies to look for online brokers that offer the tightest dealing spreads. 

Example of a Bid-Ask Spread

The level of liquidity in the market for a particular currency pair typically determines the width of the dealing spread in that pair. Dealing spreads and their width also depend on market conditions that can cause shifts in liquidity. 

Dealing spreads can temporarily widen to reflect faster market conditions and uncertainty in the forex market that can cause cautious market makers to stay on the sidelines. Spreads might also narrow in calmer market conditions and times of greater stability when more market makers feel comfortable quoting. 

For example, the EUR/USD currency pair usually has the highest level of liquidity in the Interbank forex market. It commonly exhibits tight dealing spreads of 1 pip or less in normal trading conditions, such as 1.0778/1.0779. 

In contrast, the considerably less liquid New Zealand dollar versus the U.S. dollar (NZD/USD) currency pair routinely trades with a dealing spread of 5 pips or more. A sample quote for this pair might be 0.6400/0.6405. 

Relevant economic and geopolitical news can significantly influence dealing spreads, with increased market volatility typically making dealing spreads widen. For example, if the EUR/USD currency pair was quoted at 1.0750/1.0775, the dealing spread of 25 pips would seem unusually wide for this particular currency pair. This would usually indicate a low-liquidity and/or high-risk situation that usually only occurs during the release of major economic data or geopolitical news. 

Transaction volume and the presence of many dealers and market makers are other important factors that can affect forex dealing spreads. When a large transaction to sell a particular currency pair suddenly hits the market, the exchange rate will generally soften as market makers adjust their bids lower to absorb the increased supply. Similarly, large buying activity in a currency pair will usually cause market makers to raise their offers. 

How to Calculate the Spread

Calculating the dealing spread is simple if you have a two-way quote from a market maker or broker. You subtract the bid exchange rate from the offer exchange rate. 

For example, if the exchange rate for the highly liquid EUR/USD currency pair was quoted at 1.0777/1.0779, then the dealing spread would be calculated as follows:

Dealing spread = (Offer – Bid) = 1.0779-1.0777) = 0.0002.

This means the spread would be 0.0002 or 2 pips. In an account funded in U.S. dollars, that 2-pip spread quoted in EUR/USD would equate to a cost of $20 if you cross the spread in one standard lot of 100,000 euros when trading via an online forex broker. 

This is an example of a relatively narrow dealing spread, so you can see how your trading costs can be significantly affected by wider dealing spreads — especially if you trade frequently. 

Direct vs. Indirect Currency Quotes

Two methods of quoting foreign currency exchange rates exist. One is known as the direct quotation method, while the other is called the indirect quotation method. These quotes are reciprocal of one another, and both of these methods are used in the forex market based on long-established market conventions. 

For an American living in the United States, a direct foreign exchange quote like 131 for USD/JPY refers to stating the amount of foreign currency (131 JPY) that can be bought with one unit of the domestic currency (USD). In contrast, an indirect quote like 1.2050 for GBP/USD represents the amount of domestic currency (USD) that is required to buy one unit of foreign currency (GBP). 

As another example, if you were in the U.S. and wanted a direct quote on British pounds (GBP), you would get a USD/GBP quote, which might be 0.8300 GBP per 1 USD.  If your friend was instead in the U.K. and wanted a direct quote on U.S. dollars at the same time, the GBP/USD exchange rate would be roughly 1/0.8300 or 1.2050 U.S. dollars to buy 1 GBP.  

Most currency pairs have the U.S. dollar as the base currency given the current forex market convention. Such pairs include the U.S. dollar versus the Canadian dollar (CAD), Japanese yen (JPY), Swiss franc (CHF) and more exotic currencies like the Mexican peso (MXN), and these pairs are conventionally quoted directly from a U.S. perspective.  An example of such a directly quoted pair would be USD/CAD. 

The EU’s euro and major Commonwealth currencies are typically quoted indirectly from a U.S. standpoint, including the U.K.’s pound sterling (GBP), the Australian dollar (AUD) and the New Zealand dollar (NZD). An example of this type of indirectly-quoted pair would be EUR/USD. 

Note that all quotes for exchange-traded currency futures traded on the International Monetary Market (IMM) based in Chicago use direct quotes from a U.S. standpoint. This means that some quotations for these currency futures will be the reciprocal of the quotation conventions used in the Interbank and retail forex market. 

How Important is the Bid-Ask Spread in Forex?

In general, the more actively you operate as a forex trader, the more important the bid-offer spread will be to your trading business. This means that less active trend, swing and other longer-term traders who only make occasional transactions tend to be less affected by dealing spreads. In contrast, active short-term traders like scalpers tend to be more strongly affected. 

Your broker choice and its propensity to show narrower or wider dealing spreads can significantly impact your bottom line as a forex trader. Keep in mind that because most online retail forex brokers charge zero commissions, they make most of their money by widening the dealing spread they show to you over the tighter spreads they can access in the Interbank forex market. 

Trading through an electronic communications network (ECN) broker will generally help you get tighter dealing spreads, but you may have to pay a per-trade fee in addition to paying away the narrower dealing spread. How this ultimately affects your forex trading business will need to be determined by careful analysis and review. 

Getting familiar with the typical dealing spreads for each of the currency pairs you plan on trading before you start operating in a live account can make a lot of sense too, especially if you intend to use an active trading strategy like scalping. Many online retail brokers offer demo accounts that you can use to gauge their services and check out the typical width of their dealing spreads. 

Before you open a live account and place your trading capital at risk, you might want to test your strategy in some of these demo accounts to familiarize yourself with the dealing spreads different brokers offer. This testing process can help you determine whether your strategy looks profitable enough when implemented using a particular broker to be worth your while trading it. 

Frequently Asked Questions

Disclosure: Benzinga was commissioned for this article and is not affiliated with LonghornFX. Any comments or opinions provided herein are Benzinga’s. LonghornFX does not endorse or promote any trading strategies that may be discussed or promoted herein. The broker makes no representation or warranty as to the article’s adequacy, completeness, accuracy or timeliness for any particular purpose of the above content.

This presentation discusses technical analysis, other approaches, including fundamental analysis, may offer very different views. The examples provided are for illustrative purposes only and are not intended to be reflective of the results you can expect to achieve. This article is for informational and educational use only and is not a recommendation or endorsement of any particular investment or investment strategy. Investment information provided in this content is general in nature, strictly for illustrative purposes, and may not be appropriate for all investors. Investing involves risk regardless of the strategy selected and past performance does not indicate or guarantee future results. Trading leveraged products such as Forex and Cryptos may not be suitable for all investors as they carry a degree of risk to your capital.

The post Bid vs. Ask Price in Forex Trading by Jay and Julie Hawk appeared first on Benzinga. Visit Benzinga to get more great content like this.