Chapter 6. Buy/sell rates and spreads

So far, when considering quotes, to simplify the understanding of the site material, we intentionally used only current (spot) exchange rates on Forex. In fact, any quote on Forex has two rates (two prices) – bid and ask rates. These rates are usually denoted by a slash “/”, where before the slash is the bid rate and after the slash is the ask rate, for example USD/JPY 104.75/104.85.

The bid rate is the price at which the quoted party agrees to buy the base currency from you. The selling rate is the price at which the party that issued the quote agrees to sell you the base currency. That is, the concepts of buying and selling are “inverted” in relation to you. In this wording, it is not you who buys and sells, but the party offering you the quote. In other words, if you are going to buy the base currency of the quote, you need to look at the ask price. If, on the other hand, you are going to sell the underlying quote currency, you need to look at the bid price.

For example, if you are going to buy 100 US dollars for Japanese Yen at USD/JPY 104.75/104.85, you will need 100 x 104.85 = 10,485 Japanese Yen. If, on the other hand, you are going to purchase Japanese Yen by selling 100 USD, then you will receive 100 x 104.75 = 10,475 Japanese Yen.

Depending on the trading platform, presented by Internet brokers to their clients, the graphical representation of quotes will differ. An example of graphical representation of quotes is shown in the figure.

Since the big figures of a quote (big figure) change slowly over time, they are often not displayed in the sell (ask) rate of official Forex quotes. For example, the USD/JPY 104.75/85 quote above may look like USD/JPY 104.75/85. The term big figure in dealer jargon means a base number of 100 points, so in the ask rate of a quote, as a rule, only the last 2 digits are displayed.

The difference between the sell rate and the buy rate (right and left sides of the quote) is called spread. The spread serves as a basis for profit for the party issuing the quote.

Let’s consider an exchange office with a typical Forex quote of USD/JPY 104.75/85 with a spread of 10 pips. You sell 100 US dollars and get 100 x 104.75 = 10,475 Japanese Yen. If someone else now comes and buys that 100 USD from the exchange office, they will have to pay 100 x 104.85 = 10,485 Japanese Yen. Thus, the exchange office will earn 10,485 – 10,475 = 10 Japanese Yen. As you can see from the example, an exchange office makes money on opposite currency transactions, i.e. when someone buys and someone else sells. This principle is the basis for brokerage houses to make profits in the forex market.

A profit of 10 Japanese Yen (about 10 cents in terms of US dollars) is negligible compared to a transaction amount of 100 US dollars. That is why exchange bureaus use a much larger spread than in Forex quotes, where the minimum transaction size is much larger and is about 100,000 USD. A more realistic quote for an exchange office would be USD/JPY 102.00/108.00 with a spread of 600 pips. Then the profit from a USD 100 transaction would be 600 Japanese Yen (or 5.56 USD in terms of the same quote).

We will learn how to determine the profit from a deal and convert it to the currency of interest in the next chapters of the site. At the moment it is important only to understand that in any quote on Forex there are two rates (buying rate and selling rate), and that the difference between these rates is called spread and is expressed in points.

So, the spread is a source of income for the party issuing the quote. That is why retail brokerage houses, which offer private investors the opportunity to work on Forex via the Internet, usually do not take commissions on completed transactions – they earn on the spread.

In the next chapters of the site, when we will learn how to open and close positions on Forex, it will be described in detail why a large spread is not profitable for a private investor. For now, it should be clear that when choosing an Internet broker, first of all, you should pay attention to the value of the spread offered by the broker – the smaller the spread, the better!

Where do buy and sell rates come from? Who sets them? Currency quotes are determined solely by the supply and demand of currencies on the international currency market. The main influence on currency rates is exerted by large active participants of the Forex market (the classification of Forex market participants was discussed earlier in the corresponding chapter). By picking up the main current of exchange rate changes, large passive participants and millions of small participants also influence further changes in exchange rates. Thus, if the majority of participants try to sell a particular currency, its price falls. If the main tendency is to buy the currency, its price rises. The trader’s task is to recognize this trend in time. This will be discussed in detail later in the Forex School section of the Forex Arena information portal.

For different participants of the international currency market at different times the value of the spread in the quote is not the same. For large Forex participants, making deals for millions of US dollars, the spread is minimal and is usually only a few points, as even a small spread in such deals can bring a tangible profit. For small Forex participants making transactions for smaller amounts, the spread is larger. For example, in exchange bureaus the spread can reach hundreds of points.

In conditions of unstable, rapidly changing exchange rate, the spread size can increase. Thus, in moments of frenzy of currency buying or selling, caused by the release of an important economic indicator (elements of fundamental analysis will be described in detail in the Forex School section) Internet brokers often increase the spread size, and this should also be taken into account when choosing an Internet broker – a broker with a fixed constant spread is preferable.

The spread size may depend on the market liquidity of a particular currency. If the currency is not actively traded on Forex, the spread on the corresponding quotes may be larger. This is especially true for interbank currency exchange, when banks exchange “exotic” low-liquidity currencies of underdeveloped countries. Private investors mainly work on Forex with quotations of highly liquid currencies.

For large participants of the international currency market, the spread may depend on the amount of the transaction. If the amount differs greatly from the average market amount for a particular currency, the spread may be larger. After all, large transactions expose the bank to significant risks, while for smaller amounts the bank’s costs of conducting them increase.

Ultimately, the relationship between the counterparties of the transaction may affect the spread. If the parties to a transaction have a strong business relationship, they may agree to reduce the spread. And vice versa, if the dealer of the bank does not want to conduct a transaction with a particular counterparty, he can deliberately overestimate the value of the spread in the quotation, knowingly forcing the counterparty to refuse to conduct the transaction.

So, bid, ask and spread are the key concepts when working in Forex. A private investor should clearly understand their meaning. After all, when working on Forex, decisions should be made quickly, and for this purpose there should be no problems in understanding the fundamental concepts!

A private investor should not be frightened by the fact that Forex deals are usually made for hundreds of thousands and even millions of US dollars. The principle of margin trading, which will be discussed in the following chapters of the Forex Arena information portal, allows private investors to make deals for amounts hundreds of times higher than the funds they have.