Concept #4 - Anatomy of a Trade: Bid Price, Ask Price and ‘Spread’

Forex quotes include more than just the exchange rate. They also include a bid price and an ask price. Where do these prices come from?

They come from entities known as forex market makers. These market makers consist of banks and brokerages that are ready to buy and sell currency at a moment’s notice.

If these market makers didn’t exist, you would not be able to buy or sell currency at will. There has to be someone else involved in the transaction.

It is the market maker who sets the ask price for the currency being sold. The ask price is always higher than the bid price, which is typically equivalent to the exchange rate.

So, let’s say that you want to buy Canadian Dollars. The market maker must purchase your U.S. Dollars with Canadian Dollars, so the transaction will first be expressed in terms of the exchange rate for the currency pair:

CAD/USD = 1.2

It will cost the market maker $1.20 CAD to purchase $1.00 USD from you. Good so far, right? Now, let’s say you intend to sell $100 USD.

The bid price, then, is $120 CAD for $100 USD.

However, the market maker can choose to quote a higher price for his base currency. He can, for example, quote you an ask price of $100.05 USD for $120 CAD.

On your end of the transaction, though, you will see this mark-up expressed in CAD as an ask price of $120.05. In doing so, the market maker profits by requiring you to buy a fraction more Canadian Dollars, so that he receives a fraction more in U.S. Dollars.

120.05 - 120.00 = 0.05 or $0.0005

This number represents what’s known as the spread.

The concept of the “spread” is important when determining your profit and loss because you may be subject to it both when entering and exiting a trade. The amount of the spread will vary based on whether you are the buyer or the seller.

In the CAD/USD example, you entered the trade as a buyer. The fact that you are technically ’selling’ U.S. Dollars in exchange for the Canadian Dollars does not matter here because the trade began with you responding as a buyer to a market maker’s ask price.

If you wanted to enter a trade as a seller, then you would need to respond to a bid price for currency that you already hold.

The general rule of thumb is this:

- As a buyer, you pay the spread as you enter a trade, but not when you exit.
- As a seller, you do not pay the spread as you enter a trade, but you do pay it
when you exit as buyer.

At this point, you might be thinking to yourself: “It looks like I get hit with a spread no matter what I do, because I’ll inevitably be in the role ‘buyer’ at some point on every trade.” This is true, but your profit and loss depends partly on what kind of spread you’re subject to during the transaction.

In our CAD/USD example, where you are a buyer, you are subject to the following spread on a trade of 100,000 units:

(.0001/1.2) x 100,000 = $8.33 x 5 pips = $41.65

If you close the trade as a seller at CAD/USD = 1.25 (bid price)/1.27 (ask price), you are not subject to the new spread of $0.0007 (7 pips). You simply close the trade with a sale, and subtract the spread from your profit.

However, let’s say that you already had some Canadian Dollars, and decided to enter the trade as a seller at 1.27, then close the trade as a buyer?

You would be subject to the new spread of 7 pips, or $56.

This means you have a potential gain or loss of $14.35 per lot, depending on when you enter the trade, and whether you have entered as a buyer or seller. It may not seem like much, but these types of losses and gains accrue with each trade.

As a retail trader, your margins will be small to begin with, and you can’t afford to be careless.

Speaking of margins, you may wonder how you can get involved with Forex when the average lot size is $100,000?  Read my next post to find out how.