What is a spread in trading?

What is a spread in trading?

Trading spread
Photo by @SergioL

A spread in trading is your direct cost. It’s in your interest to know what it is and how it’s calculated. 

Spreads are the difference between the bid (buy) and the ask (sell) price. On your platform you will see two prices, one that you buy at and one that you sell at. The buy is a higher price and the sell is a lower price,  with the difference between the two numbers being the spread.

Spread meaning

Although the financial spread is formally defined as the difference between the ‘bid’ and the ‘ask’ price, as a retail trader, there is no ‘bid’ and ‘ask’ price available, so we use the ‘buy’ and ‘sell’ price. In this case, the spread is defined as the difference between the ‘buy’ and ‘sell’ price of the financial instrument you’re trading.

If you’re trading a forex currency pair like EUR/USD you might see a buy price of 1.1720 and a sell price of 1.1719. The difference is the spread which in this case is 1.0 pip. You’ll therefore be charged 1 pip to enter the trade and in effect you’ll be buying at a more expensive price than the market, or selling at a cheaper price. 

How do spreads work?

The financial spread of any asset you trade varies and directly affects both the cost and the overall value of the trade.

The spread is calculated by taking the difference between the highest price a buyer is willing to pay for an asset and the lowest price a seller is willing to accept. Financial spreads are based on the current or market price of an asset. 

Brokers may add some transactional costs into the spread to simplify the transaction process.

When you trade online the spread is your cost. The tighter (smaller) the financial spread, the cheaper your transactional charge will be.

How brokers price their spreads

If your broker is plugged into an ECN (Electronic Communication Network) supply of liquidity they should be able to match your order almost immediately and at the best price available. 

Although the liquidity pool is made up of suppliers who create the ECN, the spread will vary depending on volatility and levels of supply (liquidity). 

Keeping your costs to a minimum by ensuring you deal with a broker who charges consistently low spreads is important to your success. So bear this in mind when you are looking for a broker.High transaction costs have been known to undermine otherwise sound trading plans and methods.  

Once you click buy or sell on a particular product, like EUR/USD, you will only make a profit if that market moves further than the price of the spread, and in your favour! 

Some markets may also involve a commission charge or a combination of both the spread and commission costs.

Remember, the instant you execute your trade you might be down slightly. This is because the transaction cost (the spread) has been added up front. 

What is spread betting trading?

Spread betting is a derivative method of trading because you are betting on the rate of an asset’s change in price without owning the asset. It allows you to speculate on whether the markets are going to rise or fall. So, if the market moves the way you predict, you are in profit.

This type of trading is because traders only need to deposit a small percentage of the full value of the spread bet to open a position.  This is also called “margin trading”. It means that you only need to put up a small amount of money (margin) to control a more considerable amount. If you’re feeling confident, you can leverage your money further by borrowing from your broker. While margin trading (using leverage) allows you to increase your potential gains, losses can be magnified because they’re calculated on the full value of the position. So take care.


Leverage can magnify losses
Photo by @andreyyalansky19

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Why are spreads important in trading?

Spreads are transparent and therefore enable the retail trader to calculate their cost of any trade. You can see the financial spread quoted for each and every transaction you execute and you can then compare the market spreads of various financial instruments. 

For example; it is easy to see the multiple spreads of major, minor and exotic currencies and you’ll notice that majors such as EUR/USD and GBP/USD consistently have some of the most competitive spreads. You will also find that spreads on the DJIA (the U.S.30) can be more competitive than the spreads quoted on the German equity index.

You should be aware that in volatile fast moving markets such as forex, your transaction may not be fulfilled at the lowest advertised spreads and prices. This means they could be worse, or better than those advertised. 

As we’ve said, brokers usually cover their costs by charging small spreads and/or commissions. They thrive on turnover and it is in their interest to help clients to be successful; the happier their clients the better their bottom line.  

What is a bid-offer spread/bid-ask spread?

In practice, the bid-ask spread of an asset indicates how closely matched supply and demand are for this particular financial security. If the bid-ask spread is very tight, the assumption is that the asset’s price must be close to a consensus between buyers and sellers. If there are discrepancies between the buyers’ and sellers’ valuations, then the bid-ask spread will widen.

How to calculate the spread

Take the example of a currency pair. Every forex trade involves two currencies; the base and the counter currency. If GBP/USD is at 1.30407, the GBP is worth 1.30407 times 1 USD. If you predict GBP will rise against the USD the dollar, then you buy/go long  on the GBP/USD pair.

The difference between the bid and ask quote is the spread is 1.0. That’s the profit that your broker keeps for taking the risk and facilitating the trade. This figure is the spread cost you will pay.

 

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What affects the size of spreads  

If the market is highly competitive because you are trading in peak hours and there are many buyers and sellers highly engaged in the market, then competition and demand increase. This, in turn, increases the number of traders and encourages brokers (or Market makers) to narrow their spreads to attract more business.

There is a great deal of competition between brokers or Market makers for the business of major currency pairs. But if you want to trade exotic or minor currencies, you’ll find that with less competition, spreads will be wider and your costs will go up. 

Note also that liquidity and volatility can affect the cost of the spread.

Liquidity 

The volume of trades determines liquidity. A liquid asset is one which is easily converted into cash. In the case of an illiquid asset the reverse is true and it is much harder to convert into cash. The financial assets which are most often traded have tighter spreads and those traded less frequently have wider spreads. 

A good example is say gold. You’ll see the tightest spreads on the popularly traded major currency pairs such as USD/JPY and EUR/USD. But because the market for gold is not as big as the forex, then the spreads on gold (measured in dollars) XAU/USD will be wider. 

Just to be different, the spreads on cryptos can be the widest despite the volatility. This is generally because of liquidity issues. 

Volatility

When markets are fluctuating, they’re regarded as volatile. This means you see sudden increases and rapid declines in prices. The result of this is that the spreads in these markets tend to be wide. Market makers and brokers sometimes use volatility as an opportunity to increase their spreads so look out for this. Traders often attempt to profit from such market volatility as the large price fluctuations can present trading opportunities.

Note too that the price of an asset can be linked to both liquidity and volatility. If an asset price is low, volatility can often be much higher, and liquidity much lower. This situation can cause spreads to widen. The opposite effect (i.e. lower volatility) can prevail when an asset is more expensive.

Bid-offer spread example

Let’s take a look at one example. 

Example

  • Apple stock is priced at $115 in the market.
  • Its “bid” price is $114 and the “offer” or “ask” price is $116. 
  • The spread is therefore $2.
  • $116 represents the highest price the buyer will pay for the stock and the lowest price that the seller is willing to accept to sell it. 
  • The cost or spread can also be expressed as a percentage; in this instance, it would be 0.867%.

Wide bid-offer spreads are typical for illiquid securities like Bitcoin. In some illiquid markets such as fixed income securities and small-cap stocks, you can sometimes see bid-offers spreads of over 1% of the asset’s price.

Tight bid-offer spreads are typical for highly liquid stocks, such as Apple, Facebook, and Amazon. 

Spread trading summary

As a retail trader it’s important that you understand spreads as they are the key to the costs you will pay as you trade. But they are not the only factor that should influence your decision to join a particular broker. Factors like the speed of execution, the range of markets and the overall level of service are also important. 

We’ll look in more detail at the overall costs of trading next.

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