13 Jul

Understanding Forex Bid and Ask Price

Forex has bid ask spreads, just like any financial market. In simple terms, it is the price difference between buying and selling a currency pair. This is why there is a negative figure in the “profit” column as soon as a trade is made.

Specifically, we need to define “bid price” and “ask price” before we go any further.

  • Bid Price – Used when selling currency pairs. Based on the base currency, it indicates how much of the quoted currency will be obtained by purchasing one unit.
  • Ask Price – Used when purchasing the exchange pair. In this case, it refers to the amount of quoted currency that is needed to buy one unit of base currency.

The price of a security is the market’s perspective on its value at a particular time and is unique. When considering the reasons for a “bid” and an “ask,” the two major players involved in any market transaction have to be considered, namely the price taker (trader) and the market maker (counterparty).

A market maker is an individual or company that offers to sell securities at a specified price (the ask price) and offering to buy securities at a specified price (the bid price). In order for an investor to initiate a trade, they require either one of these two price levels, based on whether they wish to buy a security (ask price) or sell a security (bid price).

Market makers collect the spread (outside commissions), which is the difference between the ask and bid price, as part of the natural flow of processing orders at those prices. Brokerages refer to this as traders crossing the spread when they say their revenue comes from it.

A bid-ask spread can be viewed as an indicator of supply and demand. When the ask and bid represent demand and supply for an asset, it is true that a change in supply and demand is reflected when these two prices expand further apart.

 

Important Considerations

It is important to consider the depth of bids and asks when calculating the bid-ask spread. In the absence of limit orders to buy or sell a security, there will be fewer bids (and fewer bid prices) so the spread may widen significantly. Hence, it’s crucial to consider the bid-ask spread when placing a buy limit order to ensure it is executed successfully.

A market maker or professional trader who recognizes imminent risk in the markets may also increase their willingness to offer a greater difference between the best bid and ask at a given point in time. All market makers doing this on a particular security will result in a larger than usual bid-ask spread. Market makers and high-frequency traders look to make money by exploiting small changes in the bid-ask spread.

Among different assets, the bid-ask spread varies more significantly because of their differences in liquidity. Market liquidity can be measured by the bid-ask spread. The lower spreads should reflect certain markets’ higher liquidity. A transaction initiator (price taker) requires liquidity, whereas a counterparty (market maker) provides it.

A currency market for example, has one of the smallest bid-ask spreads in the world (one hundredth of a percent); in other words, it can be measured in fractions of pennies. A spread of 1% to 2% may be applied to assets like small-cap stocks that are less liquid.

It is also possible for bid-ask spreads to reflect perceived risks by the market maker. During a forex or equities trade, the spread between bids and asks might represent a larger percentage of the price than a trade of options or futures. In addition to liquidity, the width of the spread might be affected by the price’s ability to change rapidly.

 

Bid-Ask Spread Example

The bid-ask spread for the stock is $1 if a company’s bid price is $19 and its ask price is $20. In percentage terms, the bid-ask spread is typically calculated as a percentage of the lowest sale price or asking price.

Based on the above stock price example, you would divide $1 by $20 (the bid price divvied by the lowest offer price) to arrive at a bid-ask spread of 5% ($1 / $20 x 100). Potential buyers and sellers would be able to close this spread if one of them offered a higher price or the other offered a lower price for the stock.

Consider another example where a trader wants to buy 100 shares of Apple for $50. The trader notices that 100 shares are on the market for $50.05. In this case, the spread is $50.00 – $50.05, or $0.05 wide. Although this spread may seem small, it can affect the value of large trades, so narrow spreads on large trades are usually preferable. Accordingly, in this case, the total value of bid-ask spread would be equal to $5 multiplied by 100 shares.

 

Elements of the Bid-Ask Spread

For an optimal exit point, being able to book a profit on a highly liquid market is key to a bid-ask spread. A spread can only be created when there is some friction between the supply and demand for that security.

Trading with limit orders rather than market orders means that traders should control their entry points in order to ensure that they do not miss out on spread opportunities. Since two trades are being conducted simultaneously, a bid-ask spread will occur.

 

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