October 23, 2013

How Forex Brokers Calculate A Bid-Ask Spread

This article looks at the bid-ask spread and provides tips on how to use it effectively.

Forex Brokers Bid-Ask Spread

In order to be an effective trader you must understand how the foreign exchange market operates.  You must be aware of the different factors involved in not only preparation for the trade, but the trade itself.  There are various terms which will be heard, such as currency pairs and bid-ask spreads, and you must have knowledge of what these mean and how they will affect your trading.

What is the bid-ask spread?

The bid-ask spread refers to the variance between a bid price and the ask price, the bid price being how much a buyer is willing to pay for the currency and the ask price being how much the trader is willing to sell the currency at.  A forex trade occurs when the buyer accepts an ask price and/or a trader accepts the big price.  This will cause an upwards movement in the foreign exchange market and an upwards trend or uptrend.  However, if the currency is sold at a lower price than is requested there will be an alteration in the supply and demand rate.  This will lead to a downtrend as the currency value drops.

The bid-ask spread must be considered when trading as it can affect the outcomes of your transaction.  However, there are other factors to be considered when looking at the spread.

What other factors must be examined?

The spread is important when perusing forex brokers as the broker earns their income off the spread.  To be sure you are working with a trustworthy broker you must understand all aspects of this trading feature, particularly those related to the bid-ask spread.

  • The spread is determined by market liquidity.  The most frequently traded currency pairs generally have the narrowest spreads, as long as no major fluctuations are seen in a country’s supply and demand.  If there is an imbalance in the supply and demand of a country’s currency then the bid-ask spread will widen.
  • The bid-ask spread represents a cost not always evident in new traders and their forex brokers relationships.  This is generally only considered among the more experienced traders or those who trade on a regular basis.
  • Spreads that widen during a steep market will decline due to a change in supply and demand.  This is when the trader ‘hits the bid’ and the buyers avoid the currency.  As a result this spreads will widen to mitigate a higher risk of loss in volatile conditions, and to dissuade and large number of trades increasing the risk of being caught in a bad trade.

Some bid-ask spread tips from forex brokers

  • Always use limit orders.  All trading involves risk thus it is important traders utilise limit orders.  It is recommended you place one position limit for the sale of currency rather than market orders.
  • Avoid liquidity.  The use of liquidity orders also increases market liquidity.  It is recommended that you avoid these changes by utilising ECNs.
  • Shop around for the best spreads.  By doing your research on forex brokers, you will be able to find the most beneficial spreads.  Pay attention to all factors included and meet the most appropriate for your trading requirements.



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