What it means
Markets for currencies, bonds, shares and many other assets rely on dealers, also known as market makers, who stand ready to trade with customers. Instead of waiting for a buyer to find a seller, the dealer quotes two prices at once and commits to trade at either.
If you want to sell, you get the dealer's bid price. If you want to buy, you pay the dealer's ask price, which is higher, so the round trip of buying and then selling immediately costs you the spread.
The size of the spread reflects how easy the asset is to trade and how risky it is for the dealer to hold. Very liquid assets, such as major currencies, tend to have tiny spreads, while thinly traded bonds or small company shares have much wider ones.
For a business, the two-way quote is the real price of a transaction. A company changing $1,000,000 into euros should compare what the bank pays and charges, not just the middle rate that appears in news headlines.
A dealer quoting two ways also takes on risk, since the market can move after the quote is given. Quotes are usually only good for a short time or for a stated size, and large orders may be quoted at worse prices.
Knowing how to read a two-way quote helps with budgeting and negotiation. Asking several dealers for quotes, and choosing the tightest spread, is one of the simplest ways to cut trading and foreign exchange costs.
In practice
Real-world examples.
Example
A manufacturer needs to convert $500,000 into pounds. Two banks provide two-way quotes for the currency. The first has a spread of 0.30% and the second 0.15%, so on the full amount the cheaper quote saves the manufacturer $750.
Example
A bond trader calls a dealer for a price on a corporate bond and hears "98.50 bid, 99.00 ask". She knows she can sell at 98.50 per 100 of face value, or buy at 99.00. She decides the half-point spread is too wide for her short holding period and waits for a better price.
Example
A retail investor buys shares in a small company that rarely trades. The bid is $2.40 and the ask is $2.60, a spread of about 8%. He realises the share must rise by that much just for him to break even, so he reduces his planned purchase.
Formula
Calculation
Spread = ask price - bid price
Spread as a percentage = spread / midpoint x 100, where midpoint = (bid + ask) / 2
A dealer quotes a share at $49.90 bid and $50.10 ask.
Spread = 50.10 - 49.90 = $0.20.
Midpoint = (49.90 + 50.10) / 2 = $50.00.
Spread as a percentage = 0.20 / 50.00 x 100 = 0.4%.
If you buy 1,000 shares and sell them straight away, you pay 1,000 x 50.10 = $50,100 and receive 1,000 x 49.90 = $49,900. The round trip costs $200, which is the spread of $0.20 multiplied by 1,000 shares.Case study
Seen in the real world.
Northwind Exports is a fictional company that sells machinery abroad, and this is an illustrative case. Every month it converted about $2,000,000 of foreign currency receipts into its home currency through its main bank, which quoted a spread of 0.50%.
The finance manager asked two other banks for two-way quotes on the same size of trade. One returned a spread of 0.20%, and the other 0.25%, both for the same settlement date. On $2,000,000 a month, the difference between 0.50% and 0.20% is $6,000 a month.
She moved most of the business to the cheaper bank and kept the original bank for emergency lines of credit. Over a year, the change saved roughly $72,000. The illustrative case shows that a two-way quote is a price to be compared and negotiated.
Watch out
Common mistakes.
- Using the midpoint price in your budget. You can never trade at the midpoint with a dealer, because you always buy at the ask and sell at the bid.
- Comparing only the headline rate and ignoring fees. The true cost includes the spread and any commissions.
- Assuming a quote is available at any size. Quotes are usually valid for limited amounts and short periods, and large orders can move the price.
Questions
People also ask.
What is the difference between the bid and the ask?
The bid is the highest price a buyer will pay, and the ask is the lowest price a seller will accept, so the ask is always higher.
Why do dealers quote two ways?
It lets them make a market by promising to trade in either direction, and the spread pays them for the risk of holding inventory.
How can I get a better spread?
Shop around, trade more liquid assets, trade in normal market hours and negotiate on larger or regular volumes.
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