Forex spread, Ask and Bid prices, what determines the size of the spread?

Every time you buy and sell a currency pair in forex, you pay a spread. Spread is the difference between the purchase price and the sale price.

One of the first concepts that a new trader encounters is the concept of supply and demand. Since most retail forex trades are completed without commissions from the broker, the bid-ask spread represents the primary cost of doing business in the market.

When a currency trader enters into a forex trade quoted by a broker or market maker, this usually means that the trader will pay in multiple pips to be able to open or close the desired position.

In the GBP/USD example above, you can see two prices that are 1 pip apart. The last fifth digit is the pipette, which we do not pay attention to. The spread is not always 1 point. It may vary depending on the currency pair, current market volatility and trading volume.

Ask price and Bid price

Ask price is the higher price at which you can buy a currency pair.

Bid price is the lower price at which you can sell a currency pair.

If you are long, you can close your trade at the Bid price (sell).

If you are in a short position, you can close your trade at the Ask price (make a purchase).

In other words, the Ask price is the price at which we open buy orders and close sell orders. The Bid price is the price at which we open sell orders and close buy orders.

Explanation of the spread

A spread is the difference between the purchase and sale prices of a currency pair. The bid price is the exchange rate at which the market maker will buy the currency pair, and the bid price is the exchange rate at which he will sell the currency pair.

As an example, consider a MetaTrader screenshot showing the bid-ask spread for the EUR/USD currency pair. The rate at which a trader can sell is 1.05716, and the bid or ask rate at which he can buy is 1.05733. The spread is the difference between given exchange rates. In this example it would be 0.00017 or 1.7 points.

Professional market makers and brokers typically make money on the spread. This gives them the opportunity to either shift existing positions or absorb them into one position at a favorable exchange rate. Essentially, the more often a market maker is able to offset one client's position with another's, the more often he can make money on the spread. Of course, he also takes on some risk if the market moves quickly in one direction.

Why is there a spread in Forex?

The forex market is different from the stock exchange, where trading takes place at a specific location. Forex is a virtual over-the-counter market where traders' trades are executed by specialists or market makers. The buyer may be in Paris, the seller in Berlin, and the market maker may be in New York. The responsibilities of a market maker are to ensure that orders to buy and sell currencies are executed for their clients. That is, he needs to bring buyers and sellers together.

The job of a market maker involves certain risks. For example, it may happen that a market maker receives an order to sell at one price, but before he can find a buyer, the price of the currency has already decreased. However, he is responsible for executing the accepted sell order and may even have to execute a buy order at a price that is lower than the sell price.

However, in most cases the price change will be insignificant, and the speed of transaction execution and matching of sellers and buyers is very fast. But due to taking the risk of incurring a loss and as compensation for the execution of each trade of traders, the market maker always withholds a certain amount from each trade of traders, which is called the spread.

What do we need to know about the spread?

In the major forex currency pairs, the majors, the spread will be quite low because these currencies are the most common and traded the most. If you want to keep the cost of the spread to a minimum, you should only trade majors. On crosses the spreads will be higher.

The lowest spreads will be during trading hours when most buyers and sellers are in the market, for example during the European or American trading session. When the number of buyers and sellers for a given currency pair increases, market makers narrow their spreads as they compete for clients to give each of them the best possible trading conditions.

Additionally, the size of your trade affects the cost of trading fees paid through the spread. Let's assume you are trading 1 mini lot and open a trade on USD/JPY. The cost of a point for you will be $1. Let's assume that the spread is 2 points. Therefore, you will be charged $2 for this transaction. However, if you open a trade for 5 mini lots, you will pay $10 per trade (5 x 2 = 10).

Some forex brokers offer fixed spreads. As a rule, they are always higher than floating spreads. Keep in mind that often brokers offering fixed spreads will limit trading during important news releases when the forex market is particularly volatile.

Each time you close your position, you pay a spread. This is the profit your broker makes every time you make a forex trade. It doesn't matter whether your trade is profitable or unprofitable. The broker will always include the cost of the spread in the purchase or sale price. Obviously, brokers love traders who make a lot of trades. They make a lot of money from such traders because of the cost of the spread.

Don't think that forex brokers make money only from the spread. Many forex companies make money by taking the opposite side of trades with their clients. Most traders lose their money and it goes straight into the brokers' pockets. This business model is more profitable than introducing client transactions to the interbank market, earning money only through spreads or commissions.

Spread and market maker manipulation

Market makers can change their spreads depending on their view of how the market will move in the near future. In addition, market makers sometimes also “read” a customer by deliberately misrepresenting the price based on the customer's past performance, open positions, or prevailing market conditions.

In practice, this reading process means that if the market maker thinks the client will become a seller, he will quote them the same spread at a price lower than the current one. If the client enters into a trade, this allows the market maker to purchase that position at a significantly better exchange rate than what is available in the interbank market.

Conversely, if the market maker believes that the client is a buyer, he may make a spread skewed upward over the prevailing market. If the client does not refuse the transaction, this helps the market maker sell the position to the client at an even more favorable rate for him.

What determines the size of the spread in Forex?

The width of the trading spread quoted by a broker or market maker tends to depend on a number of factors. First of all, we are talking about a specific currency pair, since different currency pairs tend to have different average bid-ask spreads.

In general, the most liquid currency pairs, such as EUR/USD and USD/JPY, tend to have the tightest spreads. This is because they have the largest number of active market makers who see significant trading volume on these currency pairs every trading day, and they often compete with each other for clients' business by showing them tighter spreads.

Trading spreads also tend to be lower in a higher volume market as this implies that there are more traders participating as buyers and sellers in such a market. This increases the chances that the market maker will always find interested buyers and sellers.

Additionally, as more traders look to buy, exchange rates quoted for a particular currency pair tend to rise because market makers raise their offers to balance out their positions. When more traders are willing to sell a currency pair, the exchange rate will fall because market makers are likely to fall behind customer sales and therefore lower their prices.

In large markets such as the forex market, where there is a lot of buying and selling going on at the same time, this situation tends to cause rates to rise and supply to decrease at the same time, which naturally narrows the observed spread in the market.

This phenomenon helps explain why trading spreads remain so tight in the high-volume forex market compared to many other financial markets, despite the fact that retail forex transactions typically do not charge any other form of commission that can help offset the risks of the market -maker.

Additionally, other factors can also influence and even change the prevailing supply and demand quotes quoted for a particular currency pair. In addition to trading volume, these factors include such things as market liquidity and the presence of other market participants who can quote prices and therefore compete for clients' business.

Another important factor that influences the prevailing spread in the forex market is the current level of volatility. This is closely related to the risk of sharp exchange rate fluctuations, which also tends to affect the width of the spread. Market makers quoting prices in a volatile market are taking on more risk and therefore quoting wider prices to offset the risks. Transaction spreads are especially susceptible to widening if market makers have good reason to expect sudden and sharp price movements in the market, which is especially true during key economic data announcements.

An example of economic data that can impact trading spreads is the US Non-Farm Payrolls report.

Another example of a situation that could cause forex spreads to widen would be the outcome of an upcoming political election or national referendum, such as the Brexit vote. Such news events can markedly affect the relative valuation of the currency in question and often result in significant exchange rate fluctuations, making quoting the market much more risky for the market maker.

Which traders need the lowest spreads on Forex

In the interbank market, some market makers will set a fixed spread for trades on major currency pairs, say two pips. Customer service representatives working in the dealing desk will then regularly widen these trading spreads to three points when quoting prices to their clients.

If a trader is interested in starting to trade a particular currency pair, it would be a great idea for him to first look into whether the spreads will be fixed or variable.

In general, forex traders who trade the most actively tend to require the tightest or lowest spreads to increase their profits. This is because the higher the spreads they pay, the more those spreads eat into their trading profits.

These active traders may include those who engage in scalping, day trading, algorithmic trading, or other trading strategies that involve regularly entering and exiting the market. The strategy will be especially sensitive to the spread if small profits are expected from each transaction.

Those traders who work infrequently or take long-term positions wanting to participate in multi-month trends are usually not as sensitive to the width of trading spreads. This is because they expect much larger movements relative to the width of the bid-ask spread, so the width of the spread usually has very little impact on their strategy.

Types of spread

  • Fixed spreads – This means that the difference between the buy price and the sell price of the spread will remain constant in the quotes provided by the broker, regardless of current market conditions. These types of spreads will often be provided by retail forex brokers for accounts that trade automatically so that the trader knows exactly what spread to expect as his algorithmic trading system enters and exits the market.
  • Extended fixed spreads – part of the spread for trading is set in advance, although the broker can adjust the other part depending on market conditions.
  • Variable Spreads – Spreads under this type of policy will vary in width depending on market conditions. Variable spreads tend to be narrower when the market is calm and wider when the market is actively moving. This type of spread tends to more accurately reflect market conditions, but introduces an element of significant uncertainty for the active trader, which can negatively impact his profitability.

Which brokers offer the best forex spreads?

Before choosing a Forex broker, a trader must first determine how important the spread width is.

Some traders may have very spread-sensitive strategies, while others tend to be less affected by spreads. If spread width is of minimal concern to you, you will probably want to choose any reputable and well-regulated broker that will provide good analytics and a stable trading platform.

On the other hand, if the width of the trading spread is very important to the profitability of your chosen strategy, you will take considerable time to choose a broker that offers the best spreads.

Also remember that actual forex broker spreads in practice may change from time to time depending on prevailing market conditions and other factors. Some brokers offer fixed spreads on major currency pairs, which can be an excellent option for a trader if the success of their primary trading strategy is particularly sensitive to the width of the spread.

Once a potentially suitable broker has been identified, the next step is to open a demo account to test the broker's trading spread. Then, if everything looks satisfactory, you can consider opening a live account to check if the prices on live trades match the actual spreads on the demo accounts and remain consistent.