What is a spread — how does it influence trading?

• The spread is the difference between a financial asset’s ask (buy) and bid (sell) price.
• The spread can also be called the bid-ask spread.
• The spread is common in derivative products such as spread betting and CFD trading.
• Spreads can be tight or wide depending on various factors such as supply and demand, trading volume, liquidity, and volatility.
• There are two types of spreads available: fixed and variable.
• The spread is the transaction cost that allows the broker to execute a trade on a trader’s behalf.

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

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

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

The spread can be either tight or wide. One way to define it is based on an asset’s trading volume and liquidity levels. 

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 translates 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 additional factors in the next section.

Different financial markets and instruments also have different spreads; for example, major forex pairs, such as EUR/USD or GBP/USD, have tighter spreads compared to exotic forex pairs, such as USD/ZAR.

The spread isn’t necessarily just the difference between the bid and ask price; it can also refer to a strategy used in options trading. In this strategy, an individual might buy and sell multiple options contracts on the same underlying asset, but with different prices, expiration dates, or both.

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, its value will increase. Conversely, 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: This indicates 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 can be bought or sold. If an asset’s liquidity level is higher, it usually results in tighter spreads. Conversely, if it is lower, it usually results in wider spreads.

It’s also common practice for most brokers and market makers to add their own transactional costs to the spread 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.

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

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’ll use another forex pair. However, we will use one with a lower liquidity level, such as EUR/TRY (the 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.

Any broker you might choose will always have one of two spreads available.

These are:

• Fixed
• Variables

At Trade Nation, we offer clients low-cost fixed spreads. Below, we break down each of those two spreads in more detail to provide a clear explanation.

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 from 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 the market is experiencing high volatility, and price fluctuations occur more rapidly and frequently. When this happens, the price at which the trader expects the order to be executed is different from the actual executing price.

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 could, in turn, cause 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, due to more transparent pricing, traders won’t experience requotes, as the broker receives prices from various liquidity providers. 

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

Trading variable spreads isn’t necessarily ideal for scalpers because widened spreads could reduce their potential profits.

In the beginning, we saw that the spread is the compensation that goes towards the broker as well as the trading cost to execute a trade. Now, some brokers include additional commission fees when trading CFDs together with 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. At Trade Nation, we don’t charge any additional commissions apart from the spread when opening or closing a position, regardless of whether you’re trading CFDs or spread betting.

Something traders might want to keep in mind is that the price of an instrument must first move beyond the spread to see potential profits or losses.

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.