When a trade is executed, the transaction price differs from the live market price. This means that traders buy and sell at prices slightly different from actual market prices. This is due to the spread – the difference between the quoted buying and selling price.
Here’s what you need to know about spreads in trading.
This article at a glance:
- The difference between buy and sell prices of an asset is known as the spread.
- Narrower spreads mean increased liquidity and ease of trade, whereas wider spreads mean lower liquidity.
- Lower spreads mean lower trading costs.
What is a spread?
When trading in financial markets, traders have the choice to either buy or sell an asset. Orders are executed at the ask or sell price when the asset is being bought. Similarly, they are filled at the bid or buy price when being sold.
Brokers provide separate quotes for each, leading to a gap between the buy and sell prices. This gap is known as the spread. It is pocketed by the broker or market maker as their take. Spread sizes fluctuate constantly, varying across different assets, brokers and points in time.
As an example, a stock trading at 100.00 USD may have a bid price of 99.00 USD and an ask price of 101.00 USD. The spread in this case would be 2.00 USD. Traders looking to buy would have their orders fulfilled at 101.00 USD, whereas those selling would receive 99.00 USD.
Why do brokers charge spreads?
Running a global trading brokerage with millions of dollars flowing through is an expensive setup. Brokerages are operating businesses, incur related costs like other businesses do, and look to turn a profit as well.
Subsequently, brokers charge trading fees and commissions to fund their operations. This includes spreads, and brokers often compete to offer the tightest spreads for greater user value. Deposit/withdrawal fees may also be levied (however many brokers, including INFINOX, don’t charge these).
How are spreads calculated?
Also referred to as the ‘bid-ask spread’, spreads receive their name from their calculation - the bid price minus the ask price. Various factors, such as liquidity, volume, and volatility, influence the size of spreads.
Highly liquid and commonly traded assets with a large trading volume have a narrower spread. In contrast, illiquid exotic assets have wider spreads.
Let’s take a look at an example of spreads. In FX terminology, spreads are often referenced in pips. A pip is the fifth decimal place in most FX pairs (although in JPY pairs, a point is the 2nd decimal place). If the bid price for GBP/USD is quoted as 1.3548 and the ask price is 1.35482, the spread would be 0.2 points, or pips.
In contrast, an emerging market currency pair, such as USD/ZAR, may have a much wider spread, normally over 100 pips.
Spreads can also be quoted in terms of percentages. If an airline stock has a bid price of 20.00 USD and an ask price of 20.04 USD, this results in a spread of 0.04 USD. This is calculated by dividing the spread by the ask price. In this case, the spread percentage would be 0.2% (0.04 USD / 20.00 USD).
What spreads are suitable for me?
You want to aim for trades that have narrower spreads, or brokers that offer more competitive spreads. While spreads may be marginal, they accumulate over multiple trades. Lower spreads mean lower trading costs, and therefore, greater profits.
Beginner traders with little to no experience may benefit more from lower spread assets. These tend to be widely traded instruments with high volumes, such as major stocks. More experienced traders may lean towards asset classes associated with wider spreads. Exotic currency pairs such as USD/ZAR and USD/MXN, for instance, have historically had large spreads because of their low volume.
This material is for general information purposes only and is not intended as (and should not be considered to be) financial, investment or other advice on which reliance should be placed. INFINOX is not authorized to provide investment advice. No opinion given in the material constitutes a recommendation by INFINOX or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.