The Forex markets consistently change as buyers and sellers place millions of transactions every day. Daily flows in the Forex markets generally exceed 5-trillion dollars in notional value every day. When you invest in the Forex markets you are purchasing one currency and simultaneously selling another. The goal is to enhance your gains when the value of the currency you purchased rises relative to the currency you sold. The security that is traded is referred to as a currency pair, and the rate at which you can exchange these currencies is called the exchange rate. When you execute a trade in the Forex markets, you will place a trade through your Forex broker. Brokers like Rakuten Securities Australia will facilitate your trading in a premium trading environment. You will be offered a price where you can purchase a currency pair and where you can sell a currency pair. This difference is known as the bid-offer spread or Forex spread.
How is the Exchange Rate Quoted?
An exchange rate is quoted using a ratio of one currency to another. The first currency in a pair is referred to as the base currency. The second currency is called the quote or counter currency. For example, when you see the USD/JPY, the USD is the base currency and the JPY is the quote currency. To calculate the exchange rate, you divide the base currency by the quoted currency to describe how many units of the quoted currency is needed to purchase one united of the base currency. In the example of the USD/JPY, you would need 104 yen to purchase one USD.
What is a Forex Spread
When you trade a currency, you will be offered an exchange rate that will describe where your broker will purchase the currency pair, called the bid, and where your broker will sell the currency pair, referred to as the offer. You will see a USD/JPY exchange rate that looks like 104.00/104.02. This would mean that you can purchase the USD/JPY (buying the US dollar and selling the Japanese yen) at 104.02. You would be able to sell the currency pair at 104 (selling the US dollar and purchasing the Japanese yen). The bid-offer spread is the difference between the point at which you can purchase a currency pair and where you can sell a currency pair. Rakuten Securities Australia offers its clients a fixed spread and does not ask for commissions fees. A fixed spread means that as the exchange rate changes in value the bid-offer spread will remain constant. The bid-offer spread of each currency pair can be different. The more liquid currency pairs, such as the major currency pairs, will have a tighter bid-offer spread than emerging currency pairs that are less liquid.
How the Market Environment Could Change Spreads
The market environment and specific events can alter your brokers’ spread. The time of day might alter your broker’s spread as the availability of trading partners could diminish. For example, after 6pm Eastern Standard Time, when New York has closed and before Australia is in full swing can be an less opportune time to trade the Forex markets. While the major currency pairs might retain their bid-offer spread, some emerging currency pairs might experience a widening of their bid-offer spread. Additionally, specific events will generate market volatility and could alter your broker’s spread. For example, just ahead, or just after the release of a monetary policy decision by the Federal Reserve, the bid-offer spread might become wider. If a market becomes extremely volatile in the wake of an event like a change in monetary policy, your broker might not be able to pin down the actual value of a given Forex pair and might need to increase the bid-offer spread to protect themselves from this uncertainty.
Why is the Spread Important?
The spread is an important part of your trading costs. When you transact, you will need to make at least the difference between the bid and the offer to break even. Rakuten Securities Australia offers very tight bid-offer spreads. Even with this in mind, you will need to make at least this amount on each trade to generate profit. The value of the bid-offer spread needs to be incorporated into your trading strategy as a cost, and will need to be incorporated in the way you trade the Forex markets. Additionally, the spread is important because it allows a broker to earn money without charging a commission. To make money, your broker needs to take risks. In many situations, they will be purchasing a currency pair from you and then they need to eliminate the risk by selling that currency pair to another party. If the market moves after you place a trade, your broker could lose money on the transaction. The way your broker protects themselves from market movement following a transaction is by using a bid-offer spread. You can see how the bid-offer spread works when you trade by practicing using a forex demo account provided by Rakuten Securities Australia.
The Bottom Line
The Forex spread, also known as the bid-offer spread is the difference between where you can purchase a currency pair and where you can sell a currency pair. An exchange rate is quoted using the based currency and the quote or counter currency. The exchange rate tells you how much of the quoted currency is needed to purchase one unit of the base currency. The bid is the rate where your broker will purchase the currency pair. The offer is the rate at which your broker will sell the currency pair. Factors that can alter the bid-offer spread include:
- The type of currency pair
- The time of day
- The market environment including ahead or after an important event
The bid-offer spread is important because it is a trading expense. If you purchase on the offer, you will need a currency pair to move by the amount of the bid-offer spread for your trade to break even. To find out how the bid-offer spread impacts your trading, you can evaluate this cost by using a demo account.