The foreign exchange spread (or bid-ask spread) refers to the difference in the bid and ask prices for a given currency.
The bid price refers to the maximum amount that a foreign exchange trader is willing to pay to buy a certain currency, and the ask price is the minimum price that the currency dealer is willing to accept for the currency.
The Bid-Ask Spread Defined
The forex spread represents two prices: the buying (bid) price for a given currency pair, and the selling (ask) price. Traders pay a certain price to buy the currency and have to sell it for less if they want to sell back it right away.
Example:consider that when you purchase a brand-new car, you pay the market price for it. The minute you drive it off the lot, the car depreciates, and if you wanted to turn around and sell it right back to the dealer, you would have to take less money for it. Depreciation accounts for the difference in the car example, while the dealer's profit accounts for the difference in a forex trade.
How to Manage and Minimize the Spread
You have two ways of minimizing the cost of these spreads:
Trade only during the most favorable trading hours, when many buyers and sellers are in the market.
As the number of buyers and sellers for a given currency pair increases, competition and demand for the business increases and market makers often narrow their spreads to capture it.
Avoid buying or selling thinly traded currencies. Multiple market makers compete for business when you trade popular currencies, such as the GBP/USD pair. If you trade a thinly traded currency pair, there may be only a few market makers to accept the trade. Reflecting the lessened competition; they will maintain a wider spread.
Economic/Political risks: Nations that experience tumultuous political climates or unstable economies will typically have their currencies associated with high risk. Such economies usually have fairly high inflation rates and are do not have a disciplined approach to monetary policy. As a result of this, the bid-ask spread will become larger. It is because dealers will perceive the currency as a high-risk investment, and thus will have no choice but to sell the currency at a premium in anticipation of higher investor returns.In addition, bidders will not consider the currency a viable investment and will offer lower and lower price for it. Thus, the bid-ask spread will widen and, as discussed above, trade volumes will decrease.
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