In our previous articles, we reviewed the Forex market structure and its key players. The highlight of our article is the incredibly important concept of spread in the forex market. However, before getting to the heart of the reading, we will introduce a couple of other related concepts. We’ll break down the idea of a quote and its different types. We’ll also explore the concept of the two-sided price. But the highlight of our article is the incredibly important concept of spread in forex. So grab yourself a cup of strong coffee or your favorite beverage, and let’s get started.
What Are Direct And Indirect Quotes?
Before we discuss the concept of spread in forex, we need to introduce a couple of other things that complete the picture. In the context of the forex market, a quote refers to the representation of the exchange rate between two currencies. It indicates the price at which one currency can be exchanged for another currency.
There are two types of quotes: direct quotes and indirect quotes. Firstly, a direct quote is when the domestic currency is the base currency and the foreign currency is the quote currency. It represents the amount of the quote currency needed to purchase one unit of the base currency. On the other hand, an indirect quote is when the foreign currency is the base currency and the domestic currency is the quote currency. It represents the amount of the quote currency obtained by selling one unit of the base currency.
The base currency, also referred to as the transaction currency or primary currency, is the first currency listed in a currency pair. It’s the currency against which the exchange rate is quoted. Essentially, when you’re looking at a currency pair, the base currency is the one you’re buying or selling. For instance, in the EUR/USD pair, the euro (EUR) is the base currency, while the U.S. dollar (USD) is the quote currency. So, the base currency is the one you’re aiming to exchange or trade in order to acquire the quote currency.
The choice between direct and indirect quotes depends on the convention used in a particular country or region or where you are. It’s important to understand these conventions when trading or dealing with foreign exchange rates.
For example, if you’re in the US, it’s a direct quote because the euro is foreign. But if you’re in Europe, it’s an indirect quote because your home currency’s price is expressed in a foreign currency.
Or let us look at a different example. When you do shopping at your local supermarket, the prices are expressed in your home currency. You can easily calculate how much you pay for everyday items. However, when you travel abroad, it takes a moment to convert local prices in your head. Can you relate? The concept behind exchange rate quotes is similar. Now, let us consider someone from Australia. Both the US dollar and the euro are foreign currencies for them. To avoid confusion, the professional forex market follows conventions for making and requesting quotes. But remember, there’s no consistent use of direct and indirect quoting conventions across the entire forex market.
What Are The Most Common Forex Market Conventions For Denoting Currencies?
The exhibit below shows conventions for major currencies. It displays the actual ratio of the price currency per unit of the base currency and the market terms used for each currency pair
| Base/Price Currency Code | Name Convention | Trader’s Slang |
|---|---|---|
| EUR/USD | Euro against US dollar | Eurodollar or Fiber |
| EUR/JPY | Euro against the Japanese yen | Yuppy or Euppy |
| EUR/GBP | Euro against the British pound | Eurosterling or Chunnel |
| EUR/CAD | Euro against the Canadian dollar | Euroloonie or Eurocad |
| EUR/CHF | Euro against the Swiss franc | Euroswissy or Chunnel |
| USD/JPY | US dollar against the Japanese yen | Dollar-yen or Gopher |
| USD/CHF | US dollar against the Swiss franc | Dollar-swissy or Swissy |
| USD/CAD | US dollar against the Canadian dollar | Loonie or Funds |
| AUD/USD | Australian dollar against US dollar | Aussie |
| GBP/USD | British pound against US dollar | Cable |
| NDZ/USD | New Zealand dollar against US dollar | Kiwi |
| CAD/JPY | Canadian dollar against the Japanese yen | Loonie-yen or Cadjpy |
| GBP/JPY | British pound against the Japanese yen | Guppy or Beast |
Let’s go over some key points about this table.
First, pay attention to the four currency pairs highlighted in bold: EUR/USD, USD/JPY, GBP/USD, and USD/CHF. These pairs are commonly known as major pairs or simply “majors.” They are currently the most actively traded pairs in the market. Some argue that USD/CAD, AUD/USD, and NZD/USD should also be considered majors, so we highlighted them in bold.
Second, when both currencies are mentioned in the naming convention, the base currency always comes first. For example, the code for “Euro–Yen” is “EUR/JPY.” It’s worth noting that the codes may appear in different formats, such as EURJPY, EUR–JPY, or EUR: JPY, but they all represent the same currency pair.
Third, there is a general hierarchy for quoting conventions. The base currency for quotes involving the EUR is the EUR, like EUR/USD. Then, for quotes involving the GBP (but not the EUR), the base currency is the GBP, such as GBP/USD. Lastly, for quotes involving the USD (but not the GBP or EUR), the base currency is the USD, like USD/CAD. However, there are exceptions for the AUD and NZD, as they serve as the base currency when quoted against the USD, as in AUD/USD and NZD/USD.
On an unrelated matter. The little-known fact the word “dollar” has an interesting origin that can be traced back to its German roots. It comes from the term “Thaler,” which was a silver coin used in German-speaking regions. This coin was widely circulated and gained popularity over time. The name “Thaler” itself is derived from “Joachimsthaler,” referring to a town in Bohemia where the coin was first minted.
As the Thaler coin became more widely accepted, it influenced the currencies of various countries. For example, the Spanish Empire used a silver coin called the “piece of eight,” which was also influenced by the Thaler. The term “dollar” gradually emerged as an anglicized version of “Thaler” and began to represent different currencies, including the United States dollar.
In 1785, the United States officially adopted the dollar as its currency, and it has since become one of the most recognized and traded currencies in the world. The term “dollar” has evolved from its German origins to become a global $ symbol of currency.
So, in summary, the word “dollar” has its roots in the German term “Thaler,” which was a silver coin. It gained popularity and influenced the currencies of various countries, including the United States. Today, the term “dollar” represents a widely recognized currency worldwide.
How Does the Two-Sided Price (Bid/Ask) Work?
We are getting closer to the main topic of our article: the spread in the forex market. Please do bear with us. There is one more thing that we need to make you familiar with. In professional foreign exchange markets, there is another important concept to consider when it comes to exchange rate quotes, and that is the two-sided price. When clients request an exchange rate quote from a dealer, broker, or bank, they will receive both a “bid” price (the price at which they can buy the currency) and an “offer” or “ask” price (the price at which they can sell the currency).
Interestingly, the concept of the two-sided price often causes confusion among novice retail traders. It can be challenging enough to keep track of which price to use for buying a currency pair and which price to use for selling it. This confusion becomes even more apparent when trying to close short orders on platforms like MetaTrader. By default, MetaTrader4 only displays the bid price on its charts, leading traders to use the bid price when going short (selling). However, when it comes to closing their positions, they need to use the offer price.
To display the offer price on MetaTrader4 charts, traders can adjust the settings by ticking a specific box. Unfortunately, many traders wonder why their stop-loss orders or take-profit orders don’t get triggered, and their first instinct is often to blame their broker or dealer.
So, understanding the concept of the two-sided price is crucial in foreign exchange trading to ensure accurate order placement and avoid potential misunderstandings.
When a financial institution provides a two-sided price quote, it shows the price we would pay to buy the base currency or the price we would receive for selling it. In other words, it includes the number of units of the price currency we would receive for one unit of the base currency (bid price). Additionally, it indicates the number of units of the price currency we would need to pay to the financial institution to obtain one unit of the base currency (offer or ask price).
The two-sided price quote tells us the exchange rate for buying or selling the base currency in terms of the price currency. This understanding is crucial when interpreting exchange rate quotes in the financial market.
EXAMPLE Let’s demonstrate these mechanics with a real-world example. So, imagine you’re a German tourist visiting Japan. Upon arrival, you head to the airport kiosk to exchange some of your euros (EUR) for Japanese yen (JPY). Then, when it’s time to return to Germany, you sell your remaining JPY and buy back EUR.
Now, if you’ve ever gone through this process before, you may have noticed something interesting. These airport kiosks typically display two prices for each currency they deal with a lower price known as the bid and a higher price known as the ask. So, when you exchanged your EUR for JPY, you transacted at the lower bid price. And when you exchanged JPY for EUR, you had to use the higher ask price.
Essentially, this airport exchange kiosk serves as a simplified version of a bank, dealer, or broker, although it lacks all the additional features.
Shall we summarize what we’ve learned? An exchange rate quote indicates the price of one currency relative to another, involving two currencies. Let’s clarify which currency is being bought and sold in this two-sided price quote, using the terminology we discussed earlier about the quote currency and base currency.
A financial institution provides a two-sided price quote that displays the price we would pay to buy the base currency or the price we would receive for selling it. Thus, it includes the bid price, which indicates the number of units of the price currency we would receive for one unit of the base currency, and the offer or ask price, which indicates the number of units of the price currency we would need to pay to the financial institution to obtain one unit of the base currency.
What is Spread in Forex Market?
We’ve established that the base currency’s price is displayed in terms of the price currency, with the bid consistently lower than the offer. In addition, financial institutions such as banks, or brokers buy the base currency at a low price and sell it at a higher price to generate profits, contributing to the spread, which is the difference between the bid and offer/ask.
The spread in the forex market refers to the difference between the bid price and the ask price of a currency pair. The bid price is the price at which a trader can sell a currency, while the ask price is the price at which a trader can buy a currency. The spread represents the transaction cost for traders and is essentially the profit margin for brokers.
The spread is an important concept in the forex market because it directly affects the profitability of trades. When the spread is narrow, it means that the difference between the bid and ask prices is small, resulting in lower transaction costs for traders. This is favorable as it allows traders to enter and exit positions with minimal impact on their profits.
On the other hand, a wide spread indicates a larger difference between the bid and ask prices, leading to higher transaction costs. This can reduce potential profits and make it more challenging for traders to achieve their desired outcomes. Therefore, understanding and considering the spread is crucial when analyzing trading opportunities and managing risk in the forex market.
Additionally, the spread can also reflect market liquidity. Highly liquid currency pairs tend to have narrower spreads, while less liquid pairs may have wider spreads. As a result, monitoring and being aware of the spread can help traders assess market conditions and make informed trading decisions.
Overall, the spread plays a significant role in forex trading as it impacts transaction costs, profitability, and market liquidity. Traders need to factor in the spread when executing trades to optimize their results and effectively navigate the forex market.
It’s worth noting that financial institutions in the professional forex market use various tactics to widen the bid/offer spread, but electronic dealing systems connecting global buyers and sellers have driven competition, resulting in narrow bid/offer spreads.
