Until now, talking about quotes, we have intentionally used only spot (current) Forex exchange rates to make our website easier to understand. However, a Forex quote consists of two rates (prices) - the sell rate (bid) and the buy rate (ask). These prices are usually separated by the forward slash (/) and are written in the following way: ask price/bid price. For example, USD/JPY 104.75/104.85.
The ask price is a price at which a party agrees to buy the base currency from you. The bid price is a price at which a party agrees to sell you the base currency. In regards to you, this is a buy/sell price reversal concept. As clearly seen from our explanation, it is the bidder who buys and sells but not you. In other words, if you are going to buy the base currency in the quote, you should focus on the sell (ask) price. Otherwise, if you intend to sell the base currency, you should pay attention to the buy (bid) price.
For example, if you want to buy 100 US dollars for the Japanese yen at a rate of USD/JPY 104.75/104.85, you need 100 x 104.85 = 10,485 Japanese yens. If you want to get Japanese yens by selling 100 US dollars, you receive 100 x 104.75 = 10,475 Japanese yens.
The graphical representation of exchange rates differs depending on the trading platform provided by the online brokers. Since big figures rarely change, they are displayed in a sell rate (ask) of official quotes on Forex once in a while. Thus, the above mentioned USD/JPY quote may look the following way: USD/JPY 104.75/85. The term big figure refers to the base number of 100 pips. Therefore, only the last two digits are displayed in the sell rate (ask) as a rule.
The difference between the bid and ask prices (left-hand side and right hand side) is called spread. Spread is the way a party that sets the quote can make profit.
For example, the broker offers a 104.75/85 Forex exchange rate with a 10 pip spread for the USD/JPY pair. You sell 100 USD and get 100 x 104.75 = 10,475 Japanese yen. At the same time, if someone buys these 100 USD, the amount of 100 x 104.85 = 10,485 yen will be paid. Thus, the broker will earn 10,485 - 10,475 = 10 yen. Clearly, the broker makes profit on opposite currency transactions - that is, when someone buys and sells. This is the basic principle of the broker’s profiting in the Forex market.
A 10 yen profit (around 0.1 USD) is nothing compared to a 100 USD deal. That is why, when the minimum trade size of the deal is bigger, let's say about 100,000 USD, exchange offices will use larger spreads than in Forex quotes. Consequently, a real exchange office will offer the following exchange rate for the USD/JPY quote: 102.00/108.00 with a 600 pip spread. In this case, selling 100 USD, you will receive 600 Japanese yens (or 5.56 USD).
You will learn how to calculate your profit from an executed deal in the currency needed in other chapters. For now, you need to understand that each Forex quote has two prices - ask/bid price - and that the spread is the difference between these prices calculated in pips.
Spread is a source of income for a party that sets the quote. Therefore, various brokers that provide access to online foreign exchange trading for private investors do not charge commission as a rule. Instead, they benefit from spreads. In the following chapters, the process of opening and closing positions in the forex market will be discussed. You will learn why high spreads are not favorable for private investors. For now, you need to understand that when you choose a broker, the first thing to pay attention to is the size of the spread: the lower the spread, the better.
Who sets buy and sell rates? Where do they come from? Currency quotes are set only based on supply and demand in the foreign exchange market. Mainly, these are active market participants who influence currency exchange rates (the types of market participants have been discussed earlier). Following a major change in the exchange rate, large passive participants and millions of individual traders affect further changes in exchange rates as well. Thus, if the majority of market participants seek to sell a certain currency, its price falls. If they tend to buy this currency, its price grows. So, the trader's goal is to spot this trend in time.
The size of the spread is not always identical for market participants. For major market players who open trades for millions of US dollars, the size of the spread is minimal - only a few pips, as even a small spread can bring large profits on such trades. For minor Forex players, the spread is bigger, as they deal with smaller funds. Therefore, in exchange offices, the spread can reach hundreds of pips.
The size of the spread may increase if the exchange rate is unstable and changes fast. Thus, when the number of buy and sell trades rises amid the release of important macroeconomic statistics (detailed description of fundamental analysis elements will be described in the coming chapters), online brokers sometimes increase the size of the spread. You should also remember that when you choose a retail broker. Therefore, it is preferable to pick the broker that offers fixed spreads.
The size of the spread sometimes depends on the market liquidity of a particular currency. If a currency is not actively traded in the forex market, the spread in the corresponding quotes will be higher. This is most typical for bank-to-bank currency exchange when banks exchange exotic low-liquid currencies of emerging markets. Private investors mainly deal with highly liquid currencies in the forex market.
For large market participants, the size of the spread may depend on the amount of the trade. If the sum differs considerably from the average deals in a given currency, the spread can be increased. On the one hand, all large trades entail significant risks. On the other hand, banks suffer bigger losses when conducting smaller deals.
The relationship between the parties to the deal can also affect the size of the spread. If the parties have a strong business relationship, then they can agree on a smaller spread. On the contrary, if the bank's dealer does not want to arrange a deal with a certain client, the spread may be deliberately overestimated, forcing the client to reject the trade.
Thus, the bid price, the ask price, and the size of the spread in the quote are the key concepts for trading in the forex market. Private investors should understand what these notions mean. Trading on Forex, all decisions should be made quickly therefore difficulties with understanding the basic concepts are unacceptable.
Private investors should not be spooked by the fact that deals in the forex market are usually made for hundreds of thousands of US dollars. The principle of margin trading, which will be discussed in the following chapters, allows private investors to open trades hundred times more than their own funds.