What is a spread in trading?

In derivative trading, such as spread betting or CFDs, the spread plays a key role as it is the difference between the ask (buy) and bid (sell) price of an asset, where the ask (buy) price will always be higher than the bid (sell) price.

This is prevalent whether you’re trading forex, indices, or commodities.

It’s also known as the bid-ask spread.

The spread can either be tight or wide. One way to define if a spread is tight or wide will depend on an asset’s trading volume. 

If there are many market participants for the specific asset who also agree on the buy and sell price, the trading volume will be high, which transfers over to a tighter spread. Consequently, if there aren’t many market participants who also don’t entirely agree on the buy and sell price, the trading volume will be lower, which means the spread will be wider.

Trading volume is just one of the factors which could influence the spread; we’ll take a look at some more factors in the next section.

There is also the situation where different financial markets will have different spreads; for example, in forex, the spreads will usually be tighter than in commodities such as gold or oil.

The spread isn’t necessarily just for the difference between the bid and ask price; it can also refer to a strategy used in options trading. This is where an individual might buy and sell a number of options containing different prices and expiration dates.

The spread is used when analysing the trading cost of an asset. The spread is also directly affected by the asset’s value, in other words, the supply and demand.

When the demand for an asset is high, but the supply is low, it will increase the value of an asset. Whereas if the supply is high but the demand is low, the value of an asset will decrease.

This goes hand-in-hand with other factors that could influence the value, bid and ask price, and ultimately, the spread itself.

These factors include:

• Volume: The volume is used to indicate the quantity of a certain asset being traded on a daily basis. When the volume is high, there are many market participants, resulting in tighter spreads. Now, when the volume is low, the spreads will usually be wider because there are fewer market participants.
• Volatility: This is used to indicate how often the price of an asset changes over a specific period of time, such as a day or week. When the volatility of an asset is high, which means the price changes are more rapid, the spread will normally be wider. However, the spread will usually be tighter when the volatility is low.
• Liquidity: This indicates how quickly and easily an asset is being bought or sold. If the liquidity level of an asset is higher, it usually results in tighter spreads. Whereas if the liquidity is lower, it usually results in wider spreads.

It is also common practice for most brokers and market makers to add their own transactional costs towards the spread in order to streamline the transaction process.

When using Trade Nations’ proprietary trading platform, the spread will automatically be calculated for all assets. However, knowing how the spread is calculated might still be helpful.

In order to calculate the spread, you’ll take the ask (buy) price and subtract it from the bid (sell) price. This will give you the spread value in pips.

To better understand how this will look when trading, we’ll look at some examples in the next section.

Now that you have a better understanding of how to calculate an asset’s spread let’s look at two examples: one of a tight spread and one of a wide spread. 

First, we will look at an example of a tight spread.

Let’s say you’re looking at a forex pair such as GBP/USD, which is trading with an asking price of 1.2359 and a bid price of 1.2357; you’ll subtract 1.2359 from 1.2357 (1.2359 – 1.2357) giving you a spread of 0.0002 or 2 pips.

Now, let’s look at an example of a wide spread.

Next, we’re going to use another forex pair. However, we will use one with a lower level of liquidity, such as EUR/TRY (Euro against the Turkish Lira).

Let’s say EUR/TRY is trading at an asking price of 30.5538 and a bid price of 30.5513. Again, we’ll subtract the asking price from the bid price, 30.5538 – 30.5513, which gives a spread of 0.0022 or 22 pips.

Two different types of spreads are available depending on your chosen broker.

These are:

• Fixed
• Variables

Let’s take a more detailed look into these two types of spreads.

What are fixed spreads?

Fixed spreads always stay the same; it doesn’t matter how volatile the market gets. However, the spread might differ depending on the financial asset you could be trading.

For example, a forex pair such as EUR/USD will have a different spread to a commodity such as gold. However, the actual spread of these two financial assets will stay the same regardless of price changes.

This happens when you trade through a broker that uses a ‘dealing desk’ model, meaning they purchase large positions from liquidity providers in order to offer those positions to traders in smaller sizes.

This could be beneficial as capital requirements are usually smaller, and a trader always knows the transaction costs.

On the other hand, traders who choose to trade fixed spreads could experience some drawbacks, such as requotes or slippage.

Requotes occur in highly volatile markets when prices are rapidly changing, so the transaction might get blocked when a trader wants to open a position at a specific price. At this point, they might receive a requote message asking to accept the newly quoted price for the same trade.

Slippage occurs when prices are changing so rapidly the broker cannot maintain the fixed spread, which happens after a trader enters a position but ends up paying a different amount for the position to the one they intended.

What are variable spreads?

Variable spreads are the opposite of fixed spreads, which constantly change as the bid and ask prices change.

The bid and ask prices can change due to trading volume, liquidity, volatility, and supply and demand, which, in turn, could affect the spread to widen or tighten.

This type of spread is offered by brokers who don’t use the ‘dealing desk’ method, which means they receive their prices from various liquidity providers and offer them to their traders.

Variable spreads could be beneficial because traders won’t experience requotes due to more transparent pricing, as the broker receives prices from various liquidity providers. 

Unfortunately, slippage in any of these two types of spreads is possible.

For scalpers, trading variable spreads won’t necessarily be ideal because widened spreads could take away from their potential profits.

As mentioned at the beginning of this article, the spread can be seen as compensation for the broker as well as the transaction cost to execute a trade.

Now, if you’re trading CFDs, additional commission fees might still be payable to the broker, including the spread. However, if you’re spread betting, there might not be any additional commission fees payable, as most spread betting brokers don’t charge a commission.

When trading an asset, it might be essential to remember that the price first has to move beyond the spread to see potential profits.

So, if you are looking to open a long position, the price must first move above the spread before potential profits could be taken. The same is true for when you might want to open a short position; the price must first move below the spread before any potential profits could be made.