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Price and spread

Concept of "price" and "spread". Demand and supply and their influence on pricing.

Price is the cornerstone of trading. No matter what goods we are talking about, every time the situation may be described like this: a seller considers the value of these goods to be lower than value of money he wants to get, and a buyer considers the value of goods higher than value of the money he is ready to pay for these goods. If the opinion of the value of goods and money is opposite, then transaction takes place only in case that a seller and a buyer agree on the price. At Forex the goods are money, but it does not change the sense of the trading. Here we take into consideration the value of one currency against the other.

The main question that a trader should decide on - is "how the price will change?" (in that or this financial instrument). On this basis he will build his opinions about the value of that or this currency. If he thinks that one currency will grow in its price against the other he will take decision to buy it. Otherwise - to sell it.

To make forecasts about the price changes more successful you must know how it is formed and what it depends on. One of the fundamental statements of Dow Jones' theory is that "the Price takes into account everything". It means that the level of current price reflects all the factors that can influence it (economic, technical, political, natural and others). Most traders have no doubt about verity of this phrase. However, it is impossible to take into consideration "everything" (it means endless quantity of factors), and this can be a reason for certain indefiniteness in the consciousness of a beginning trader.

We will take into consideration a simple model (from the point of view of technical analysis and regardless fundamental knowledge). In correspondence to this model, in conditions of absolutely free market the price depends on demand and supply. Demand is a total volume of the financial instrument that traders (bulls) in the market will want to obtain in near future. The demand is determined by claims for purchase set at the market ( it means that it is not enough to have only a desire: it is necessary to set an order to influence somehow the demand). Supply, on the contrary, is a total volume of this financial instrument that is set for selling by traders (bears).

The influence on demand and supply looks as follows:

  • the increase in demand (new buyers come to the market (traders-bulls)) means increase of prices;
  • the increase in supply (new sellers come to the market (traders-bears)) means decrease of prices.

We say "as a rule" because there are situations when increase in demand is followed by corresponding increase in supply. In this case trade volumes might become significantly bigger without any change of price. Likewise the supply increase might be "swallowed" by simultaneous increase of demand. That is why it is possible to discuss a foundation of more or less significant price movement if the changes bring to "deformation" of the level of demand and supply.

Spread is the difference between the lowest price of supply (bid) and the highest price of demand (ask). The size of this difference constantly changes as the market always forges ahead. Let us see it on the following example. In certain time period the rate of pair EURUSD is equal to 1.37513/1.37541. It means that in this time period it is possible to buy euro at the price of 1.37541 (it is the lowest price at which you can buy it) and it is possible to sell it at the price of 1.37513 (it is the highest price at which you can sell it). In this case spread is equal to 28 points (2.8 of standard point).

Each trader wants to buy at the lowest prices and to sell at the highest ones (this is one of "golden rules" of trading). If, for example, you do not want to buy at the price of 1.37541, you can set an order for the purchase at the level of 1.37500 and wait until the price reaches this level. However, it will happen only if demand does not increase, and the supply exceeds the demand at least a bit. In this case the sellers have nothing else to do than to lower price until it reaches the level of 1.37500 - then it will be sold to you at the desirable price (and so you can buy it at the price of 1.37500). And in opposite case: you are not ready to sell at the price of 1.37513. You set the order, for example, at 1.37550 level and wait until the price reaches it. It can happen in case if supply does not increase, and demand exceeds supply, at least, a bit. Then the buyers will have nothing to do than to buy at higher price. Sooner or later one will buy from you at the price of 1.37550.

As a matter of fact it has to be noted that spread (that is also known as "rate differences") takes place not only at Forex. The difference between price of purchase and selling is a part of every exchange office or bank. However, in Forex this difference is the lowest possible.