In the world of trading, the difference between the bid price and the ask price for something, such as a company share, is called the spread.

How to calculate the spread

In the forex markets, currencies are traded in pairs and the price of a currency is always quoted in terms of its price in the other currency that makes up the pair.

Example: A commonly traded currency pair is the USD/AUD. The first currency of a pair is called the base currency and the second currency is the counter currency or quote currency. In this case, USD is the base currency and AUD is the counter currency / quote currency. If you buy 1 USD and pay 1.5000 AUD for it, that would be expressed as USD/AUD 1.5/1 or simply USD/AUD 1.5.

When you log into an site for retail forex trading, you will see both bid prices and ask prices. The bid price is the price for which the forex market maker is willing to buy the base currency. The ask price is the price for which the forex market maker is willing to sell the base currency.

Example: For the currency pair USD/AUD the bid price is 1.3129 and the ask price is 1.3134. The price difference is 0.0005. Thus, the spread is 0.0005.

What’s an FX market maker?

An FX market maker is an entity that assumes the risk of holding currencies to facilitate the trading in those currencies. Once an order from a client arrives, it can be executed immediately. The market maker will sell from its own inventory or seek an offsetting order.

Market makers are not unique to the FX market; they are for instance essential to the smooth running of stock exchanges. Nasdaq have over 500 member firms that act as Nasdaq market makers and without them the exchange would run much less efficiently.

Beware of the spread

A highly liquid market will typically have very small spreads, and this is certainly true for the major currency pairs traded on the FX market. On the interbank market, where large banks trade currency among each other, the spread is usually only a few pips. When banks then quote exchange rates to their governmental, institutional and large corporates clients, the spread might be a tad larger, but not by much. For us mere mortals at the retail level, spreads tend to be significantly larger. An finally, when exchanging physical bills and coins, the spread can be huge.

If you’ve ever exchanged currency in a bank, FX kiosk at the airport or similar, you have probably noticed the huge price gap between the ask and bid prices. When you want to exchange your 100 USD into AUD, you get 125 AUD. But when the customer behind you in line hands over 125 AUD to the teller and asks for USD, she only gets 95 USD.

Be picky when you chose

Since the market makers set the spreads, the spread for a particular currency pair can vary from one retail trading platform to another. This is one of the many reasons why it is important to employ a critical eye and check out several FX trading platforms before you sign up.