How To Calculate The forex Bid Ask Spread
The bid-ask spread is the difference between the bid price for a security and its ask (or offer) price. It represents the difference between the highest price that a buyer is willing to pay (bid) for a security and the lowest price that a seller is willing to accept for it. A transaction occurs either when a buyer accepts the ask price or a seller takes the bid price. In simple terms, a security will trend upward in price when buyers outnumber sellers, as the buyers bid the stock higher. Conversely, a security will trend lower in price when sellers outnumber buyers, as the supply-demand imbalance will force the sellers to lower their offer price. The bid-ask spread is an important consideration for most investors when trading securities, since it is a hidden cost incurred when trading any financial instrument -- stocks, bonds, commodities, futures, options or foreign currency.
The following points need to be borne in mind with regard to bid-ask spreads:
Spreads are determined by liquidity, as well as supply and demand for a specific security. The most liquid or widely traded securities tend to have the narrowest spreads, as long as there is no major imbalance between supply and demand. If there is a significant imbalance and lower liquidity, the bid-ask spread will expand substantially.
Spreads on U.S. stocks have narrowed since the advent of "decimalization" in 2001. Prior to that date, most U.S. stocks were quoted in fractions of 1/16th of a dollar, of 6.25 cents. Most stocks now trade at bid-ask spreads well below that level.
Bid-ask spreads represent a cost that is not always apparent to novice investors. While spread costs may be relatively insignificant for investors who do not trade frequently, they can represent a bigger cost for active traders who make numerous trades daily.
Spreads widen during steep market declines because of the supply-demand imbalance as sellers "hit the bid" and buyers stay away in anticipation of lower prices. As a result, market makers widen the spread for two reasons: (1) to mitigate the higher risk of loss during volatile times, and (2) to dissuade investors from trading during such times, as a larger number of trades increases the risk to the market maker of being caught on the wrong side of the trade.
Examples of the Bid-Ask Spread
Example 1: Consider a stock that is trading at $9.95 / $10. The bid price is $9.95 and the offer price is $10. The bid-ask spread in this case is 5 cents. The spread as a percentage is $0.05 / $10 or 0.50%.
A buyer who acquires the stock at $10 and immediately sells it at the bid price of $9.95 -- either by accident or design -- would incur a loss of 0.50% of the transaction value due to this spread. The purchase and immediate sale of 100 shares would entail a $5 loss, while if 10,000 shares were involved, the loss would be $500. The percentage loss resulting from the spread is the same in both cases.
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Example 2: Consider a retail forex trader who buys EUR 100,000 on margin. The current quote in the market is EUR 1 = USD 1.3300 / 1.3302.
The bid-ask spread in this case is 2 pips. The spread as a percentage is 0.015% (i.e. 0.0002 / 1.3302) of the traded amount of EUR 100,000.
Specifically with regard to forex spreads, take note of a few important caveats:
Most forex trading at the retail level is done using a great deal of leverage, because of which spread costs as a percentage of the trader's equity can be quite high. In the above example, assume the trader had equity of $5,000 in his or her account (which implies leverage of about 26.6:1 in this case). The $20 spread amounts to 0.4% of the trader's margin in this instance.
For a quick calculation of the cost of the spread as a percentage of your margin or equity, simply multiply the spread percentage by the degree of leverage. For example, if the spread in the above case was 5 pips (1.3300 / 1.3305), and the amount of leverage was 50:1, the cost of the spread as a percentage of the margin deposit is as much as 1.879% (0.0376% x 50).
Spread costs can add up quickly in the rapid-fire world of forex trading, where traders' holding period or investment horizon is typically much shorter than in stock trading.