Did you know that it’s a fact that more than 50% of Forex traders don’t understand spreads.
It is critical you understand the basics so you can calculate your risk and reward, so let me share with you a simple and effective way to understand the spread.
Before I begin to explain about the bid and the ask, those of you that have come from other markets to the forex market, it does operate slightly differently. Unlike the stock market where we are charged a flat commission on our trade or in the event we buy a very large position in the stock market it might be a percentage of our trading size. In the forex market, we have what we call a spread to overcome and that’s essentially the way in which the broker makes its return on investment, providing you the opportunity to use the platform and trade into the foreign currency markets.
The brokers are essentially being quoted their prices from intra-banks, big institutions around the world that enable them to create a market for us being smaller investors to trade. Some currencies around the world have far more liquidity than others and therefore often the prices on offer are better than those less traded currencies.
Some of the major currency pairs around the world today that we like to trade at LTG GoldRock are trading pairs such as EURUSD, GBPUSD, USDJPY, and essentially the major economies around the world. These are the ones that are most commonly traded in margin forex trading and that is exactly the market we are talking about. Essentially when we are buying and selling a position in and out of the forex market, we are taking a position with the broker. The broker is creating a market for us and giving us an opportunity to participate in the foreign currency market. Therefore there is always what we call a bid price and there is also an ask price. The bid price is always the price that you see on the screen, for example if the currency pair that i mentioned before the EURUSD is showing a price of 1.4374 on your platform, this is always what we call the bid price.
Now in currency trading we have an oppoutunity to take a long position, buy into the market and sell at a higher price and we also have an opportunity to go short in the market which means we are selling and we are buying back at a lower price to flatten our trade position. Lets keep things simple and lets talk first of all about when we are buying into the market and essentially wanting the price to rise and for us to exit at a higher price and make a profit. When we click on our new order window, we will see that we see 2 prices. One is called the bid and one is called the ask. We always buy at the higher price. This is an actual fact the price by which the broker is willing to sell us this order at, we buy at the high price, which is the ask price, and in this example on this currency pair, the spread, the difference between the bid, where the current price is, and the ask price which the broker is asking us to pay is 2 points (EURUSD), some traders call them pips, in this example in this blog post we’ll call them points.
The EURUSD is a common 2 point spread with most brokers, so if we enter a trade we will enter, if we are buying always at the high price which is the ask price here so it is very important for you to appreciate that when we enter a trade and we see the price on our platform what we are actually paying when we are buying is infact the ask price and in this example on the EURUSD which is very common we have a 2 point spread. Now because there is a 2 point spread here, immediately on our platform in our profit and loss window it will show that you are minus 2 points or if you are trading with $1 per point it would show you as being minus $2 because it is filled you at the ask price, therefore the market will need to move 2 points in our favour, rise in value 2 points before we stand to make a profit. When we exit in our trade we will be exiting at the profit target and as we have entered and the spread has been taken in consideration, as soon as the trade hits our profit target, wherever we have placed that profit target, we will sell at the bid price and exit our trade.
Let’s look at a different example this time and this time we will use the AUDUSD. Again we will be buying. Before we go further you will see on your terminal screen that all different currencies have different spreads, if you have ever wondered the reason why that is, essentially it’s because of what is called liquidity and the volume on offer on these particular currencies at the time of for the brokers. Some of them are much more liquid therefore they are able to offer a far better spread. For example there are some currency pairs that offer pretty wide spreads, for example the GBPAUD, the spread is often 9. We wouldn’t be interested in trading that particular pair because simply we don’t want to the market to move 8 points before we start making a profit. We usually will only trade currencies that have a spread of 5 or less and most of the time we will be placing trades on currencies that have spreads genuinely somewhere between 2 to 3.
Let’s get back to the example and in this case we’ll go back to the AUDUSD and it will usually have a spread of 3. There are some brokers in the forex market that base their spread on the volume on what is happening in the foreign markets today. There are other brokers that set their spreads at a fixed spread each day. At the end of the day it won’t make a major difference to your profit position at the end of the month if you are using a broker that has a difference in spread of 1 point. But certainly I would encourage you not to trade with brokers that have very large spreads and take notice of whenever you set up a broking account to ensure that the spreads you are being offered are very competitive. If you are a trader at LTG GoldRock, we are always at the fore front of what is happening in the market and we will be able to give you the best advice we can on those relevant brokers who offer the most competitive rate.
So when we are talking buying the AUDUSD the current price maybe 0.9225, however what the broker is willing to allow us to buy this currency for here is the ask price which is 0.9228 and in this example 3 points is the spread. So if we click the buy button here it will fill us into the market at 0.9228 and it will show up on our platform as us being minus 3 points simply because we have given up 3 points to be able to trade this particular pair and we must overcome the spread before we start to see a profit. So therefore we have bought at the high price which is the ask price and when we sell our position, we will sell our position at the bid price and exit our trade? O
Of course the platform will replicate across all of the other currencies that you chose to are trade but just be careful not to trade and take positions with brokers that have large spreads of anywhere more than 5, and of course if you are here at LTG GoldRock we’ll ensure that does not happen.
Being able to go short and make money when a currency falls in value is certainly one of the majors reasons why people are attracted to Forex but we need to understand how going short is affected on our platform.
When we go short (sell) we are actually buying back at a lower price and exiting the market and flatten our position. In an example of going short we are selling into the market, in fact we sell at the low price, which is the bid price and again just like we were going long, we’ve got a 2 point spread we need to overcome. This time we will be filled at the bid price (going long we are filled at the ask price) when we hit the sell button and our platform immediately will come up infront of us with minus 2 points because that is the spread that the market offered us when we entered the trade.
Here is the key you MUST KNOW! Traders often say to me that the price will come to their profit target exceeds the profit target and wonder why it hasn’t exited the trade. IMPORTANT! Remember we entered this time because we went short at the actual bid price. The platform hasn’t taken into consideration the spread when we go short until it actually reaches our target, in other words, to keep things simple when we are going short it must exceed our profit target by whatever the spread is before it will sell our position. The reason is because we’ve entered at the bid and thats what happens when we go short, when we go long we actually enter at the ask price, the higher price, but when we are going short we enter at the lower price.
So don’t be confused when you go short in the market and the price comes to your profit target. It actually needs to go whatever the spread is, past you profit target and it will then sell your order.
So keep that in mind when you are going short, when we are going long, we are entering at the ask price, the higher price and the spread is taken out on our entry, when we are going short, we are entering at the bid price and the spread is taken out on our exit.
It’s really important for you to appreciate that when we do go short and when we want the base currency we are trading to fall it does need to move through our target whatever the spread amount is for us to exit our trade. Now if you would like to have the profit target taken out at a particular price, you’ll just need to ensure that you are taking consideration the spread and move the profit target the distance of the spread closer to wherever you want to get out.
I hope you found this post simple and straight forward and easy to follow, if you have any questions you can post a comment here on the blog and we will certainly get back to you as quick as we can.
