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Bid, Ask, Spread – what they are, and how they need to be factored into your calculations

2010 October 31
by cheeseweasel

My take profit was hit, why wasn’t my position liquidated?

I ran into what appeared to be a strange issue the other day – as you’ll know if you’ve been reading, all of my trades are pending orders with the stop loss and take profit fixed on entry. So one of my sell orders was triggered, price headed to my take profit, appeared to overshoot it by about 3.5 pips before heading back. My take profit wasn’t triggered, I was still in the trade, and price headed dangerously towards my stop loss. In this case the loss wasn’t triggered, and price went on to hit my take profit. I wasn’t actually sure what could cause this to happen (I thought maybe something to do with being on a demo feed), so I checked with my broker to find out as I’m only trading demo currently, I was a bit concerned about this sort of thing happening on a live account.

Aah, it’s because of the bid and the ask prices…

The explanation was that it was to do with the bid and the ask, it’s pretty obvious, and I really should have thought about this before. I remember reading that you paid the spread when you entered the trade, so kind of ignored the spread issue from then on. ┬áJust goes to show don’t trust stuff you read on the net on face value, find out for yourself!

Anyway, how it works is that there are always two prices – a buy price (ask), and a sell price (bid). These prices are actually the nearest pending orders on the market. The difference between the ask and the bid is the spread. Everyone who’s spent more than an hour looking into forex knows what the spread is – it is essentially the cost of any trade.

Now, when you go long, you buy at the ask, and when you go short, you sell at the bid.

Simple.

However, when you liquidate a long position, you’re essentially selling, so you liquidate at the bid price, and conversely when you liquidate a short position, you’re buying, so you liquidate at the ask price.

The reason this caused me problems is that my platform – MetaTrader – only displays one price (so say to remove complexity, though that means it’s not showing you the true story) – the bid price.

This can make short positions confusing.

Now for long positions, you open the position at the ask, and liquidate at the bid, since metatrader just displays the bid, the price displayed is the price at which you’ll liquidate, so there’s no real confusion about what’s going on – the spread is essentially paid when you enter the trade.

It gets less clear when you’re dealing with a short position – you open the position at the bid, and close at the invisible ask. This means that the price that will trigger your stop loss or take profit on a short position is not displayed on your chart.

(In this case the spread is paid when you close a short position, and since spread is variable on most accounts, you can never know how much you’ll pay for your position, but let’s not go there right now. ;) )

Stop losses will be triggered before price reaches your stop.

Take profits will be triggered after price crosses your TP.

So what do you need to do about this?

Well, the most obvious thing is to be aware of the spread whenever you open a short position, and factor that into your calculations.

Since I discovered this, I always add the current spread to my stop loss, and my take profit for every short position I open.

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8 Responses leave one →
  1. October 31, 2010

    I learn t this lesson very early in my trading career and always add the spread to my stops. Its very annoying when you see your position stopped out and price never really reached it. One tip is, I always use what I call the maximum spread to add to the stop. What I mean is spreads can vary depending on market volatility, news etc. At these times they can widen and you may experience a similar situation. So for example my broker charges a 2 pip spread on the euro but I will always add 4-5 pips to my stop to compensate for these times.
    I now it may sound trivial but you will be surprised the amount of times it keeps you in the trade to go on to your profit target. Just something you may want to consider.
    Trade well
    perry
    Perry recently posted..Pin Bar Candlestick Reversal Pattern

  2. cheeseweasel permalink*
    November 1, 2010

    I would imagine most traders learn this lesson fairly early – as you say it’s very frustrating to see a trade get stopped out that shouldn’t have done!

    Thanks for the tip about using a ‘maximum spread’. I guess you’ll never know the maximum spread, but an extra buffer to account for spread volatility under normal conditions is a great idea.

  3. November 7, 2010

    One thing is true that mostly new trader will already know about spreads and they mostly have read or learn on how to deal with them already. But after reading this post, I am sure that you brings a more in depth explanation of what and how spread’s works.

    Bid’s and Ask’s are different on each broker. So it is maybe a little bit confusing for first timer to get a grip at this without some good explanation. Trading is a process, be able to trade is a never ending learning and one can start by looking for great trading basic like this one…

  4. fanatic christian permalink
    December 4, 2010

    like duh dude, stick to meditation….

    • cheeseweasel permalink*
      December 6, 2010

      Thanks. :)

      I’m not shy about being a noob, it’s kind of the point of this blog.

  5. January 1, 2011

    Very nice article. I had this experience in the early days of my trading. I couldn’t understand why in the beginning even though I see the prices reaching my take profit levels. Even though I have the idea now, this article made me more clear on this.

    Thank you,
    Raj.
    Raj recently posted..ZIGZAG Breakout Strategy

  6. Jonas permalink
    February 24, 2012

    This is great article and something I was looking for. Recently I was taken out of a trade and spoke to my broker and found out that the invisible ask price hit my stop although the bid didnt. I thought something was up with the broker (like most traders perhaps). The trade went on to a decent 1:3RR which was so annoying, but at least I learnt a lesson out of it and now factor in the spread and a few more pips just incase. Sure with the widening spread it can still take you out but at least your doing everything you can to stay in the trade whilst managing risk. Thanks for the article!

  7. cheeseweasel permalink*
    February 24, 2012

    Hey, thanks for the feedback, it’s nice to know that someone found it useful. :)

    Yeah like you say, no matter what you factor in, you can never be guaranteed that it will cover you for the trade because spreads aren’t fixed, but you’re doing the best you can with the available info.

    I wish there was an easy way to show bid and ask in Metatrader…

    In fact, while I’m wishing, I wish there was just one price. :)

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