Bid and Ask Spreads

The prices of foreign exchange currency pairs are quoted as bid and offer spreads, with the bid being the selling price and the offer being the cost to buy. Thus, if EUR/USD is trading at 1.4256/1.4258, a trader wishing to go long (buy) would buy the currency pair at 1.4258, while a trader wishing to go short ( sell) would sell the currency pair at 1.4256.

The difference between the 2 costs, in this case, is 2 pips, or 0.0002 (a pip is usually measured as 0.0001).

Generally, the more liquid a currency pair is, the lower the bid/ask spread will be. The liquidity of a pair is decided by the number of trades taking place on it, so the most frequently traded pairs generally have the smallest bid-ask spreads.

How Forex Providers Make Their Cash

The forex market is a market where traders can trade commission-free. This means that currency exchange providers make their profits from the differences between the bid and ask costs.

In the case of the EUR/USD pair quoted at 1.4256/1.4258, a long trader would buy the pair at 1.4258. The pair, now priced at 1.4256 on the market, would have to rise 3 pips for the trader to make a one pip profit at 1.4257, a second pip at 1.4258 (the break-even point) and a third pip to 1.4259. The two pip move where the trader breaks even is where the forex provider takes profit from him.

What is price shading?

Foreign exchange providers generally add pips to the prices that banks quote them to widen their margin. Price shading is when a currency exchange provider, believing that a particular currency will move in a certain direction, will add pips to one side of the currency quote. Therefore, if a foreign exchange provider assumed that the EUR/USD pair would go up, they could quote the pair at 1.4256/1.4260, instead of 1.4256/1.4258, which means that a trader going long would have to buy the pair at 1.4260.

Consequently, the currency pair would have to move 5 pips for the trader to make a profit, and the four pip move in which the trader broke even would be the foreign exchange provider’s profit.

In general, if there are many more buyers than sellers of a currency pair, a provider will shade the buy side by adding pips to the bid cost. Likewise, if there are many more sellers than buyers of a currency pair, a provider will shade the sell side by adding pips to the bid cost.

why it works

If there were 500 consumers and 500 sellers of a certain currency pair, and the currency provider had added one pip to each side of the interbank quote, the provider would earn one pip for each trade (or 1,000 pips).

If there were 300 customers and 700 sellers, the provider would add 2 pips to the bid price and no pips to the bid cost.

So the interbank rate for the EUR/USD pair is 1.4255/1.4256 and the broker quotes at 1.4253/1.4256, which means sellers are selling at 1.4253 while buyers are buying at 1.4256. Since the number of sellers in the market is greater than the number of buyers, the currency pair loses value. The pair wants to drop 2 pips for the sellers to break even (from 1.4255 to 1.4253), and the forex provider makes those 2 pips of profit. That’s 1400 pips of profit for 1000 traders.

The easiest way to use this to your advantage

To determine if your forex provider is using price shadowing, you need to compare the quoted costs to those quoted by Reuters or Bloomberg, or create an account with 2 providers, one of which is a straight-through broker who will charge a commission instead . profit on the bid/ask spread.

If your supplier’s costs are consistently skewed to one side, it means that most orders from retail customers come from that side. Because most retail investors are often wrong, you can trade the other side if the bias is on the buy side you can sell, and if the bias is on the sell side you can buy.

Also, since these spreads hurt the majority by reducing your profits (remember, your currency pair wants to cross the ask/buy spread to break even before you can make a profit), you will gain an advantage by not losing the shadowed pips . , essentially entering your position at a better price than most investors.

When selecting a forex broker

Any broker that does not charge a commission for forex trading will make a profit on the bid/ask spread; and it is the trader’s responsibility to compare different forex providers to understand their commission structures and how they are paid.

A merchant should choose a reputable provider based on the strength of the business, their service history, the awards they have won, and whether they are regulated by the regulatory authority in their country. A good forex provider will offer this information for free, along with transparent information about their spreads, accessible on their website or by phone.

As forex spreads can vary due to liquidity levels in the market, a good forex broker should pass narrow spreads on the underlying market to clients, as well as having a maximum spread limit.