As you already know, currency pairs in the foreign exchange market are always made up of the base currency and the quote currency, such as GBP/NZD or USD/GBP. The reason they are quoted in pairs is that in every foreign exchange currency pair transaction, traders simultaneously buy one currency and sell another.
The first listed currency is known as the base currency (in the example below, it’s GBP). It always has a value of one. The second listed currency on the right is called the counter currency or quote currency (in the example below, it’s USD).
But no worries, currency pairs are not very complex instruments and you can easily understand what is the bid and ask prices and what is a spread.
Now, how about we throw a new term in…. An exchange rate of foreign currency pairs.
When you are trading the foreign exchange markets, an exchange rate of a currency pair is simply the ratio of one currency valued against another currency. So, in forex trading, if you buy for example the GBP/USD this simply means that you are buying the base currency and simultaneously selling the quoted currency. Or, in other words, to put it simply, you’re buying the British Pound (GBP) and selling the US dollar (USD).
Unlike other financial markets, currency pairs are traded in pairs, and each side of the exchange rate represents the national currency of a country or an economic zone. Simply, currencies’ exchange rates fluctuate based on supply and demand, which usually is determined by interest rates and the central bank monetary policy.
In the example below, we can see the exchange of the British Pound versus the US dollar.
When buying, the exchange rate tells you how much you have to pay in units of the quoted currency to buy 1 unit of the second listed currency. In the example above, you have to pay $1.27223 to buy £1. When selling, the exchange rate tells you how many units of the quoted currency you get for selling 1 unit of the base currency. In the example above, you will receive $1.27223 when you sell £1.
Exchange rates in the Forex market are expressed using the following format:
Base currency/Quote currency = Bid/Ask
Bid, ask spreads, I hear you scream? Let’s cover their meanings below!
Forex brokers that typically offer you a trading platform will quote you two prices for a currency pair: the bid price and ask price, which is known as the forex spread. But what is exactly the bid price and ask price (or buy and sell price)?
In a foreign currency pair quote, the bid represents the price at which you can SELL the base currency. If you want to sell something, the forex broker or currency dealer will buy it from you at the bid price (if you are using a market maker broker). Otherwise, you’ll sell the base currency to another forex trader or market participant.
For example, in the quote GBP/USD 1.8812/1.8815, the bid price is 1.8812. This means you sell £1 for $USD 1.8812.
The ask is the market price in a currency trade at which you can BUY the base currency. If you want to buy something, the broker or other traders in the forex market will sell (or offer) it to you at the ask price.
For example, in the quote EUR/USD 1.2812/1.2815, the asking price is 1.2815. This means you can buy €1 for $USD 1.2815.
So, what is a forex spread? Very simple – It is the difference between the bid and the ask price that is called the spread. It’s just like if you were trying to sell your old monitor to a shop that buys used ones. (Now that you’re a trader you’ll need a new, bigger one!). In order to make a profit, the shop will need to buy your monitor at a price lower than the price they’ll sell it for.
If the store can sell the monitor for $600, then the store most likely wants to make any money, and the most it can buy from you is $599. That difference of $1 is the bid-ask spread.
Generally, forex spreads are a crucial factor in forex trading as well as in selecting a good forex broker. When you enter a forex trade, you essentially start the trade with a loss because there’s a bid-ask spread between the two currencies. In most cases, this difference in prices is basically what you pay to your broker, and only if the market moves in your direction (to cover the cost of spread), you’ll then see a profit in your trade.
Forex brokers offer two types of forex spreads – variable or fixed. While fixed spreads stay constant at all times, variable forex spreads fluctuate when market conditions change and usually are a better solution for a day trader.
Another factor to take into account is that a forex spread varies depending on the instrument you are trading and its liquidity. Wide spreads are more common in foreign currencies that are less liquid (minor and exotic currency pairs) while tight spreads are more common when trading major currency pairs like the EUR/USD, USD/JPY, and AUD/USD. For that reason, many traders choose to trade major currency pairs to avoid a wider spread and to be able to easily get in and out of positions.
In conclusion, a forex spread is the primary transaction cost when you are involved in forex trading. It is, therefore, not a surprise that you need to understand what forex spreads are as they are the primary cost of trading currencies and can have a huge impact on the way you trade the markets.
Nonetheless, as you can see, understanding the bid-ask spread of a foreign exchange forex pair is not that complex. And, once you make your first trade in the forex market on a demo account or on a live trading account, it would be easier for you to clearly see the buy and sell spread on a given currency pair.
Now, I know that’s a lot of new trading terms we covered! Let’s move on to the next lesson.