In every currency quote, there are always two figures quoted. The first one on the left hand side is called the bid, and the second on the right hand side is called the ask. The difference between the two is called the spread.
The bid, the lower of the two prices is the one at which you can sell the base currency. If we go back to our EUR/USD example in Fig 3.10, the bid price is 1.30110 and is the price we would get if we sold the euro against the US dollar. In other words the bid price, is the price at which the market will buy.
On the other side we have the ask price, and this is the price at which the market will sell to you which of course is higher. Why? Well the forex broker has to make a profit and their profit is generally, (although not always) in the spread, which is the difference between the two prices. In this case the spread is the difference between 1.30110 and 1.30136 or 2.6 pips.
What does this mean? As a matter of fact, several things.
First, the spread that is quoted will vary from broker to broker and also throughout the trading day. It is not fixed and will change according to market conditions. If the market is volatile and moving quickly then the spread will widen, possibly to several pips or more, and then gradually move closer again once the volatility has passed. The reason for this is that your broker has to cover all his or her customers positions, and in a fast moving market the risks are much higher. Some brokers do offer fixed spreads in all markets, and while this may seem attractive when other brokers are widening their spreads during a news release, there are always pros and cons. After all, major news releases are relatively infrequent during the day, and for the rest of the period, a fixed spread broker is likely to be less competitive than a variable spread broker. As always, it is swings and roundabouts, and there is no such thing as a free lunch. But I digress!
The spreads are also widened during volatile trading sessions for a very different reason, and that’s to stop you taking advantage of a fast moving market. Many brokers actively discourage scalping trading (taking short term
trades for a handful of pips) during these periods when markets are fast moving, and one of the ways brokers do this is to widen the spread to such an extent it is impossible to get into a strong position. You will hear this promoted as a trading strategy, often referred to as ‘trading the news’. It does not work I’m afraid. You are welcome to try. It sounds good in theory, but in practice fails with the broker making sure for good measure!
Which leads me to the second point. Whenever we open a new trading position, we automatically start with a small loss. This reflects the fact we have entered at one price, and now have to wait for the the spread to be absorbed by any market move, before we can move into profit in due course.
Imagine this as though we are starting a race, but giving everyone else a 2.6 pip start, taking our earlier example from Fig 3.10. Before we can catch up and move into profit, we have to recover the spread first. It’s the cost of the trade if you like, and is the profit for the broker that has to be recovered. Imagine trading stocks. Here you pay a commission when you buy or sell. This is just the same. In the forex market the commission just happens to be in the spread with most brokers. There are some, where you pay a commission instead, just as in buying and selling stocks, and I explain this in the chapter on the types of brokers. In return, you get a tighter spread quoted. But again, it’s swings and roundabouts.
Finally, spreads reflect the liquidity of the currency pair, and by liquidity I mean how heavily the pair is traded, which is why as novice traders, the best pairs to start with are the major currency pairs. First they are heavily traded throughout the trading session, with the EUR/USD the most widely traded of all, particularly through the European and US sessions. This will be reflected in the spread which will generally be quoted at somewhere between 1 and 2 pips. Other major currency pairs will have slightly wider spreads, generally averaging somewhere between 2 and 3 pips. However, move into the cross currency pairs, or exotic currency pairs, and the spreads will jump much higher, so 6, 7, 8 pips or more and into double figures. Everything of course is relative.
If you are trading over days and weeks, then a few pips here or there on a spread are irrelevant. However, if you are looking to take a few pips from the forex market as a scalping trader, then the spread becomes significant, and a significant percentage of any gains or losses. Consider this for a moment.
Suppose you are trying to take just five pips from a price move, but the spread on the pair is 2.5 pips. That’s equivalent to 33% of the total move, and to put
this into context, is the same as giving someone a 33m start in a 100m race. The chances are you would lose, and lose easily! This is one of the many reasons that it is so difficult to be consistent using this approach, as the maths is heavily weighted against you. Move to something a little longer term where perhaps we are looking for 20 or 30 pips, and the spread becomes far less significant, and is then simply the ‘cost of trading’.
The other point about the spread is this - those currency pairs with tighter spreads will also signal a pair which will move continuously and smoothly throughout the day, simply because there are so many buyers and sellers in the market. This will be reflected in the price chart, which we will cover in a later chapter. Exotic currency pairs will stop and pause, sometimes for minutes or longer, before jumping in price one way or the other. This is simply because there are insufficient trading volumes to move the market in a continuous way. As a result, the market stops and pauses before moving on, making these pairs very difficult to trade on an intra day basis.
What we are looking for when we start trading is those pairs which move smoothly, and this is always the case with the major currencies, and most of the cross currency pairs. There will be periods of volatility, but never periods where the market just stops. Where you will see this however, is in the futures market, particularly on some of the less liquid contracts which are relatively new. For example, a micro futures contract on the EUR/USD will not move smoothly, even though it is derived from a major currency pair. It is simply that the volume of trades in this contract is relatively low at present, and this will be reflected in the associated price action.
Having covered the basics of how foreign exchange rates are quoted and what they mean, in the next chapter we’re going to look at some of the forces which drive the forex markets, and are then reflected in the constant ebb and flow of these rates.