Liquidity and the Bid-Ask Spread: The important concept but easy forget by forex beginners

There are several factors that influence the size of the bid-offer spread. The most important is currency liquidity. Popular currency pairs are traded with lowest spreads while rare pairs raise dozen pips spread. Next factor is amount of a deal. Middle size spot deals are executed on quotations with standard tight spreads; extreme deals – both too small and too big – are quoted with broader spreads due to risks involved.

On volatile market bid-offer spreads are wider than during quiet market conditions. Status of a customer also impact spread as large scale traders or premium clients enjoy personal discounts. Nowadays Forex market characterizes high competition and as brokers are trying to stay closer to customers, spreads tends to be fixed on lowest possible level.

Each trader should pay sufficient attention to spread management. Maximum performance can only be achieved when maximum quantity of market conditions is taken into account. Successful trading strategy is based on effective evaluation of market indicators and specific financial conditions of a deal. The best tools here are complex analysis, forecasting, risk/return analysis, transaction cost evaluation. Because spreads are subject to change, spread management strategy should also be flexible enough to adjust to market movement.

A tighter spread signifies a more liquid market. Higher liquidity means more buyers and sellers and more market makers. As buyers compete with one another, the bid price rises and as sellers compete, the ask price falls. The result is a tighter spread between the bid and ask price.

The bid-ask spread amounts to a trading cost for traders. In other words, a market with a lower spread is cheaper to trade. Liquidity often leads to more liquidity, as traders are attracted to markets with lower bid-ask spreads.

Bid-Ask spread is used in following arbitrage trades:

1) Inter-market spread : When a trader buys the futures of a security having a particular expiry on one exchange and sells the same security contract with a near-expiry on another exchange,

2) Intra-market spread : When the contract of one security is bought and that of another security is sold on the same exchange e.g. gold and silver spread trade,

3) Calendar spread : When a security contract of one expiry date is bought and another contract of the same security with a different expiry date is sold on the same exchange.

Some of the important elements to Bid-Ask Spread: 1) The market for any security should be highly liquid, otherwise there may be no ideal exit point to book profit in a spread trade.

2) There should be some friction in demand-supply of that security, because that creates chances for a wider spread.

3) A trader should not use ‘market order’ for spread trade, otherwise the spread opportunity can be missed. It’s wise to use ‘limit order’ where the trader decides the entry point.

4) The range of a spread trade is relative to that particular security market, it’s not same for all.

5) Always check Bid-Ask Spread ins and outs, and look for spreads either in absolute or percentage terms for individual security. If it’s a margin trade, then use spread percentage.

6) Bid-Ask Spread trade involves a cost, as you are doing two trades simultaneously.

7) Bid-Ask Spread trades can be done in almost all kinds of securities, but they are quite popular in forex, interest rate yields and commodities.

Understanding the Bid and Ask in the Forex market

You can use a limit price to get a better price, but doing so may mean you miss a trade if the price moves beyond you. A market order will ensure that you don’t miss an opportunity, but your execution price won’t be as good.
For this reason, it’s important to look at the bid and ask price, and the last traded price – which is usually labelled ‘Last’ on trading platforms.

The table above shows the Bid, Ask and Last price for four currency pairs on MetaTrader5. By looking at the last price, you can see whether the price is being traded on the bid or ask side of the bid-ask spread.

The top two currencies both had their last trade at the bid price. That means other traders were selling at the bid price. In the case of the bottom two pairs, the last trades were at the ask price.

The colours also indicate whether the bid, ask and last price are higher or lower than their previous level. Blue means the price is higher and red means it is lower.

By looking at the bid-ask spread and the direction prices are moving in, you can determine whether you should use a limit order and limit the market price towards you, or use a market order to make sure the price doesn’t escape you.

When trading in the Forex market, the bid-ask spread will have an impact on the strategies and the timeframes you trade.

The above example from Metratrader5 shows the bid and ask prices for the EUR/USD pair, which is very liquid, and for the USD/TRY pair which is far less liquid. The spread for the first pair is 0.9 pips, whereas the spread for the second is 90 pips. 

For a trade to be profitable, the price needs to first move enough to cover the bid-ask spread. In the above example, if you buy at the ask price, the bid must move that much higher before you will break even. In the case of the EUR/USD pair, the bid needs to only move 0.9 pips, but in the case of the USD/TRY pair, it needs to move 90 pips just for the trade to break even.

The tighter a spread, the lower the time frame that can be traded. The EUR/USD pair can be traded in time frames as low as 1 minute, as the pair will move enough in a short space of time. A less liquid pair like the USD/TRY pair will need to move a lot further, which will probably take a lot longer.

When considering a trading strategy, you will need to consider the spread too. If the average profit is less than the spread, you may not be able to trade the strategy in a profitable manner.