Bid and ask prices are the prices at which buyers and sellers are willing to trade. The bid-ask spread is the difference between the lowest price at which you can buy something and the highest price at which you can sell it. The spread is a key consideration for traders in not just currencies but in all financial markets. Understanding how and why the spread fluctuates will make you a more efficient investor.
Spread and Trading Costs
When you pull up quotes for a currency pair, you will typically see two prices -- for example, EUR/USD 1.11 - 1.12. This means that you can immediately buy one euro for $1.12 or sell one euro for $1.11. The spread is the difference between these two prices and in this case is 1 cent. The spread is the cost you'll incur if you buy and then sell at the prevailing prices. Starting with $1.12, you can buy one euro, but if you then sell it you may expect only $1.11, resulting in a net loss of 1 cent.
A broad rule that applies to all financial instruments is that the higher the trading volume, the lower the bid-ask spread. This is because a higher volume means more buyers and sellers, which increases the probability of finding willing buyers and sellers at any given time. The more eager buyers are to purchase, the higher the prices they will offer. The more eager the sellers are to unload a currency, the lower the prices they will accept. Hence, in a market with plentiful buying and selling volume, bids will rise, asks will drop, and -- consequently -- the spread will narrow.
During times of high risk and uncertainty, the spread tends to widen. If, for example, the outcome of elections and therefore the future economic policies in the United Kingdom formed a big question mark, the spread in dollar vs. British pound sterling trading would be likely to go up. This is because traders dislike risky situations and scale back trading activity until the dust settles. With fewer active traders in the market, the spread will widen. While broader spreads mean higher trading costs, uncertain times also offer significant profit opportunities for investors who can successfully forecast future events.
Presence of Dealers
In addition to traders who buy and sell to profit from fluctuations in foreign exchange rates, some institutions, usually large banks, act as dealers in the foreign currency markets. These dealers make money mostly as a result of the spread, as they intend to sell at the ask price and buy at the bid, thereby making profits without holding on to any currency for too long. The more such dealers there are in the market, the lower the spread. Think of the spread as the profit margin of dealers. As more dealers compete for the funds of traders, competition will squeeze the margins and reduce the spreads.
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