Bid-Ask (Offer) Price Definition
When entering a buy order, your order needs to match with a seller, and when selling your order needs to match with a buyer. That means when you are given a quote:
- The bid is the price at which you can sell
- The offer is the price at which you can buy
In normal circumstances, the bid price is lower than the ask price. The difference between these two prices is referred to as:
- bid-ask spread
- bid-offer spread
- or usually just the spread
How to read a Quote
Forex quotes will sometimes just display the bid price, and the last digits of the ask price. For example, if the bid price for EURUSD is 1.1200 and the ask price is 1.1205 the short version will be quoted as:
EURUSD 1.1200 / 05
This quote means you can buy at 1.1205 and sell at 1.1200. Looking at it from the other side the dealer who gave the quote will buy from you at 1.1200 and sell to you at 1.1205.
The Bid-Ask Spread Formula
The currency unit of the spread depends on the quote currency. This means that the spread for EURUSD is quoted in US dollars whilst the spread for EURGBP for example is in pounds sterling.
If EURUSD is quoted at 1.2 and EURGBP is at 0.8 for instance that means the spread for EURGBP is going to appear correspondingly smaller because it’s quoted in GBP.
For that reason rather than working with points or pips it is always advisable to calculate the spread as a percentage of the mid-price. To do that we simply use the spread formula:
Spread % = 2 x (Ask – Bid) / (Ask+Bid) x 100 %
How Market-Makers Set the Bid-Ask Price
Foreign exchange transactions don’t take place on exchanges, but rather through networks of forex broker-dealers who make the market. This is what’s called an over the counter (OTC) market. Here the dealer is the price maker and the buyers and sellers of the commodity being traded are the price takers.
In the same way as any wholesale to retail business, the dealers publish the price at which they are willing to buy and the prices at which they are willing to sell. In an OTC market it’s the dealers who’ll set the bid-ask spread in a way that keeps the market moving (liquid) and allows them to make a profit.
To a trader, the spread is a transactional cost. To the market maker, the spread is profit.
A trader (client) pays half of the spread cost on the trade open and the other half is paid on the close.
What Affects the Spread and Why?
Markets are active and this means spreads are not fixed. Spreads change throughout the trading day as dealers adjust it up or down to compensate for risk and to stay competitive in line with other market makers.
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The aspects that influence spreads the most are liquidity, volatility and time.
With a fast and liquid market, it’s much easier for a dealer to balance buyers and sellers and therefore remain market neutral. A very deep market, like EURUSD for example allows the dealer to quote a narrower spread. A less liquid market such as EURNOK say would usually be quoted with a wider spread because the volume is that much less.
The second aspect is volatility. When the market is moving rapidly dealers need to compensate for this risk with a wider spread. This is necessary to stay market-neutral and mitigate the risk of building a position against the market.
Finally it’s worth keeping in mind that most broker-dealers will widen spreads considerably just as the market is closing. This is to hedge against the uncertainty during the closed period and when the market reopens – for example over the weekend.
Bid-Ask Spread Example
The graphic below shows how the spread on GBPUSD varied throughout one day. The red dots represent higher spreads and the green lower spreads. While this chart is for GBPUSD it is a fairly typical picture.
Notice how the spreads increase around the times of economic releases. The midday period is especially busy on this day with a central bank interest rate announcement followed by some manufacturing data and jobs data from the US.
The highest spread is 4x the lowest spread. That means the cost of trading at these times will be 4x greater.
The graphic below shows the size and frequency of spreads on GBPUSD for the same day. The red bars show the higher spreads, and the green bars the lower spreads. The blue is the average spread, which on this day was around 0.017% of the price.
Day Trading Strategies and the Costs of Spreads
A buy-to-hold trader could probably live with the spread cost of 0.017% per trade which is around 2.2 pips. But for a day trader it’s a different story.
As we’ve shown before, high spreads can quickly turn a profitable strategy into a loss maker.
For illustration let’s say a day trading strategy has an expectancy of 5 pips per trade – before fees. The 2.2 pip spread would reduce the profit by over forty percent. If the trader was unlucky and hit the higher spreads of 3 pips and up, that would take up 60% or more of profits in spread fees alone.
Tips to Avoid High Spread Costs
Anyone who’s done day trading will know that trading fees are the biggest enemy.
Every order placed can experience latency and slippage. In the time an order is placed to the time it’s filled the spread may already have widened.
Typically there isn’t any way to cancel an order or prevent a broker-side stop loss firing because of a spread widening.
As best practice there are some simple rules to try to minimize spread cost.
- Check the range and rate of change of spread for a few minutes before placing market orders
- Avoid entering or exiting the market during economic announcements
- Wait for volatility spikes to clear
- Don’t place active orders that might fill during the market open or close.
Another good tip is to avoid trading in the few minutes before the top of the hour or the bottom of the hour. This is when most of the major news releases are and this is when spreads are often widening.
With a strategy that’s coded into software it should be possible to set the range of acceptable spreads. This is harder to do when trading manually which is why the above rules will help.
How do Exchanges Use Bid Ask Prices?
Of course many tradeable instruments like stocks, commodities, options and futures aren’t over-the-counter at all but are traded on central electronic exchanges such as NYMEX or the London Stock Exchange.
Electronic exchanges bypass the dealer middle-men and just bring buyers and sellers together automating the whole process. So how does the bid-offer work here?
When the market is open the exchange is receiving live orders to buy and orders to sell. The market orders – which mostly originate from retail traders – execute immediately at the going price. The bulk of liquidity is usually in the form of sell-limit and buy-limit orders. The buy limit orders make up the bids and the sell limit orders are the offers.
The exchange aggregates these bids and offers and from this sets the live quote. Figure 1 shows a simplified account of how this works on most modern exchanges. The green bars show buy-order volume and the red sell-order volume.
Whenever a bid and offer “cross” – meaning a seller will sell at or less than what a buyer is willing to pay – the exchange instantaneously matches and fills as much volume as it can for those orders. This means the buyers always buy at the lowest offer rate, and the sellers sell at the highest bid rate.
Therefore on most exchanges it’s the buyers and sellers who are setting the bid-ask spread, rather than it being set by a dealer sitting between them, as is the case with an OTC market.
Spread Trading Strategies
If you’re on the paying end, the spread can never be a good thing because it’s always a cost.
Yet spread-data when looked at across the market can provide some useful insights.
Dealers tend to widen or narrow spreads in anticipation of market activity. This means spreads can often be a measure of implied volatility – or volatility levels that may be coming soon.
In much the same way as VIX, the spread and its rate of change can be useful to anticipate changing markets:
- Increasing spreads forecast towards rising volatility or lowering volume
- Decreasing spreads forecast towards lowering volatility or increasing volume