Traders want to receive payouts
The main reason why people get into trading is to receive payouts from the process - that’s the motivation that lies behind every single trade. It doesn’t matter whether we are talking about service providers or individual traders, they want to buy and sell securities at a beneficial price to them.
And to determine those prices, the two sides - buyers and sellers - engage in the negotiation process. That is where we encounter two of the most important elements of every trade - the bid and ask prices. Here’s how they work:
- A bid price is offered by a buyer of a certain asset. It represents the maximum amount of money that they are willing to pay for it and they usually try to make it as low as possible;
- An ask price is offered to a buyer of an asset. It represents the minimum amount of money that the buyer is willing to take for it and they tend to demand as high a price as possible.
Now, this might seem a bit difficult to understand. So, here is an example that shows the bid and ask rate in Forex in simpler terms:
The ask and bid quote example
Let’s assume there is a trader named Josh who wants to buy a USD/JPY currency pair for, say, 100,000 Japanese yen. And after he has bought the pair, he’ll wait some time until the exchange rate increases to sell the pair and receive a payout. To do that, Josh finds a service provider - a broker, who has satisfying trading conditions for Josh.
Now, one would assume that the price for buying and selling the USD/JPY pair should be the same. So, if Josh buys about 911 dollars at the asking price of 109.69, he should be able to sell that same amount of yen and get 100,000 yen back, right?
No, that’s not how this system works, even though it might seem logical to many people. Instead of the same bid and ask price offerings, the two prices are different from each other.
Therefore, if Josh buys 911 dollars with an asking price of 109.69, that will most probably be the maximum amount he will get as a result of the given trade with 100,000 yen. However, if Josh decides to sell the dollars and buy yen again, he’ll probably get fewer of it back.
For the sake of this example, let’s assume that the bidding price is 109.67. This means that the buyer will pay Josh 99,909 yen back - assuming that the overall exchange rate remained the same at that time.
What does buying/selling a currency pair mean?
This real-life example of Josh and his trading experience on the foreign exchange market demonstrates how the bid and ask prices work. Now, there is one more thing to clarify: when we are talking about the Forex bid ask price, and also mention a certain currency pair like the above-mentioned USD/JPY, it means that we’re buying US dollars with Japanese yen. In general, buying a currency pair means just that: traders use the second currency - a base currency - to buy the first currency in the pair.
Now, let’s talk about the price point which is satisfying for sellers and buyers of these assets. As we mentioned earlier, the bid price is the maximum that a buyer is willing to pay for an asset. This means that there is a certain point beyond which the price becomes too large for a buyer (usually a broker) to pay. And since every broker wants to buy assets as cheaply as possible, they try to lower the price by negotiating with the seller.
On the other hand, the asking price, as you already know, is the minimum that a seller is willing to receive from the buyer for an asset. And when the asking price goes lower than a certain point, it’s just not worth selling at all. Therefore, the asking price is basically what the offer price means: a certain price offered to the seller of a pair.
So, the negotiation process is where traders and service providers determine a certain price which is satisfying for both parties - sufficiently low for buyers and sufficiently high for sellers.
Forex ask and bid price difference - who benefits from it?
So, one of the things that are most apparent from this example is that the bid price is almost always lower than the asking price. That is because the difference between the two prices is what generates a payout for the service providers/brokers.
To get back to our example, when a provider offered Josh an asking price of 109.69 but decreased the bidding price at 109.67, the difference of 0.02 - which is considered 2 pips for JPY-based pairs - resulted in a payout. Therefore, in real numbers, a service provider received $2 from the trade.
The difference between the bid and ask prices is called a spread. In most cases, brokers and other service providers in Forex don’t have commission fees on trading. That’s because there are spreads that can do the same thing - provide financial support to the broker.