Exchange Rates and Spreads in Forex Markets
An exchange rate is simply the ratio of one currency valued against another. The first currency is referred to as the base currency and the second as the counter or quote currency. If buying, an exchange rate specifies how much you have to pay in the counter or quote currency to obtain one unit of the base currency. If selling, the exchange rate specifies how much you get in the counter or quote currency when selling one unit of the base currency.
base currency/quote currency
A currency exchange rate is typically given as a bid price and an ask price. The bid price is always lower than the ask price. The bid price represents what will be obtained in the quote currency when selling one unit of the base currency. The ask price represents what has to be paid in the quote currency to obtain one unit of the base currency. The following EUR/USD price quote is an example of bid/ask notation:
EUR/USD: .9726 / .9731
The first component (before the slash) refers to the BID price (what you obtain in USD when you sell EUR). In this example, the BID price is .9726. The second component (after the slash) is used to obtain the ASK price (what you have to pay in EUR if you buy USD). In this example, the ASK price is .9731.
The difference between the bid and the ask price is referred to as the spread. In the example above, the spread is .0005 or 5 pips. Unlike the EUR/USD, some currency pair quotes are carried out to the 2nd decimal place (i.e. USD/JPY may be quoted at 119.45/50), in which case 5 pips represents a difference of .05. Although a pip may seem small, a movement of one pip in either direction can translate into thousands of dollars in gains or losses in the inter-bank market.
When trading amounts of $1M or higher, the spread obtained in a quote is typically 5 pips. When trading smaller amounts, the spread is typically larger. For example, when trading less than $100,000, spreads of 50-200 pips are common. Credit card companies typically apply a spread of 200-300 pips. Banks and exchange bureaus typically use a spread in the range of 200-1000 pips (in addition to charging a commission).
Most currencies are traded directly against the US Dollar. The market rates that are expressed for such currency pairs are called direct rates. In most cases, the US Dollar is the base currency pair whereby the quote currency is expressed as a certain number of units per 1 US Dollar. For example, the following rate USD/CAD=1.4500 indicates that 1 USD (US Dollars)= 1.4500 CAD (Canadian Dollars).
For some currency pairs, the US Dollar is not the base currency but the counter or quote currency. The market rates that are expressed for such currency pairs are called indirect rates. This is the case with GBP (British Pound or Cable ), NZD (New Zealand Dollar), EUR (Eurodollar), and AUD (Australian Dollar). For example, the following rate GBP/USD=1.5800 indicates that 1 GBP (British Pound)= 1.5800 USD (US Dollars).
When one currency is traded against any currency other than the USD, the market rate for this currency pair is called a cross rate. Cross rate is the exchange rate between two currencies not involving the US Dollar. Although the US dollar rates do not appear in the final cross rate, they are usually used in the calculation and so must be known. Trading between two non-US Dollar currencies usually occurs by first trading one against the US Dollar and then trading the US Dollar against the second non-US Dollar currency. There are a few non-US Dollar currencies that are traded directly, such as GBP/EUR or EUR/CHF.
To actively trade currencies, one has to understand their value, the exchange rate and bid and ask prices as well as the concept of the spread. Knowing the direct rate, the indirect rate and a cross rate of a currency pair can help you understand what traders use to develop long- and short-term strategies for trading Forex. You can learn more about basic entry and exit rules for trading foreign exchange here as well as how to calculate your profits and losses. Ready to try a demo account and get started trading Forex on your own? Click to open a FXDD demo account.
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