Defining Bid-Ask Spread: How Does It Work in Forex Trading?
Unravel the intricacies of the bid-ask spread and discover how exchange rates influence this critical factor in forex trading. Understand why it's essential to your trading strategy and how to navigate it effectively.
Updated January 10, 2024.
When investors are about to make a purchase of a stock, they might notice a bid price and an ask price on their trading platform dashboard.
The bid-ask spread refers to the difference between the prices quoted for an immediate sale or purchase of a stock, currency pair, or commodity futures contract. Exchange rates can play an important role in the bid-ask spread, therefore, understanding how they are calculated can be a critical tool in realizing the impact of the bid-ask spread.
- Ask price is what the forex market is willing to sell the currency.
- Bid price is what the forex market is willing to buy the currency.
- The spread is the gap between the ask price and bid price.
- Exchange rates inform you how much your money is worth in another currency.
- The spread can also confirm liquidity conditions in currency markets.
Understanding Exchange Rates in Forex Trading
For the most part, exchange rates are based on supply and demand in the global financial market. In other cases, exchange rates might be fixed or pegged to the value of another country's currency. They tell you how much your currency is worth in a separate currency. Forex traders might also monitor the spreads to determine broader liquidity conditions in currency markets.
At first, it might appear confusing, but once you regularly trade forex, it becomes second nature.
For example, if you are thinking about trading USD/CHF, this is the Swiss franc-to-dollar exchange rate. The currency on the left is the base currency, while the currency on the right is the quote currency. If the USD/CHF exchange rate is 1.5, this means one Swiss franc will purchase $1.50. Should the exchange rate climb, this signifies that the base currency has surged in value and vice versa.
Bid-Ask Spread in the Forex Market Explained
In forex trading, the bid price is what forex investors are willing to pay for a currency, and the ask price is what forex traders are willing to sell the currency. As a result, the bid-ask spread references the gap between the buy and sell price.
So, let's use the USD/CAD currency pair as an example: USD 1 = CAD 1.30 / CAD 1.40. The higher price is the cost to purchase each US dollar and the lower price is what you would get if you were to sell the currency. Therefore, the bid-ask spread would be ten pips.
Here is a brief explanation for all three:
- Ask price: The price traders are willing to sell.
- Bid price: The price traders are willing to buy.
- Bid-ask spread: The difference between the buy and sell price.
For instance, this past fall, the euro cratered against the US dollar, with the exchange rate plummeting to below parity for the first time in 37 years: 0.9970. This meant that one US dollar was worth more than one euro.
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The bid-ask spread is not something you should ignore when hitting the buy or sell button on your trading platform. It can either help or hurt your trade when you open or close the position.
Ultimately, whether it is a couple of pips or a few-dozen pips, traders can learn the current state of a currency pair by how wide the spread is during any given session.
Note: Fortrade offers the ability to trade the price changes of instruments with CFDs and NOT to buy/sell ownership of the instrument itself