A spread refers to the difference between the highest price a buyer is willing to pay (the bid price) and the lowest price a seller is willing to accept (the ask price) for a financial instrument like a stock, currency, commodity, or else.
Spread and its size
The spread is like a transaction cost for buying or selling the asset. It is typically measured in pips or points (1 pip = 10 points), which are the smallest units of price change for that particular instrument.
The difference between the ask and bid prices is the spread, which serves as the broker’s commission. The spread, which can vary based on market conditions like price volatility, trading volume, and liquidity level, is the primary trading cost for traders. The spread can also be influenced by other factors such as the trade’s size and the time of day.
A narrow spread indicates high liquidity and lots of trading activity for that asset. A wide spread suggests lower liquidity and trading activity. Traders need to take the spread into account when making decisions because it can impact the profitability of a trade.
For example, the most liquid currencies like the US dollar, Euro, and Japanese yen may have narrower spreads, whereas less commonly traded currencies like emerging currencies may have higher spreads.
Traders must pay attention to the spread’s size while making any trade since it can impact the trade’s profitability. Using trading tools can help traders monitor and analyze the spread to make informed trading decisions.
In the picture above, the spread equals 1.08653 – 1.08647 = 0.00006 = 0.6 pip.
Types of spread
There are two main types of spreads in financial trading:
Fixed spread. A fixed spread is set at a constant and consistent rate over time. It doesn’t vary based on market demand and supply. Fixed spreads are typically used in financial instruments that have low trading volumes, such as some major currency pairs.
Floating spread. A variable spread changes in size over time, depending on market demand and supply. When trading volumes are high, the spread can decrease in size, and when trading volumes are low, the spread can increase in size.
Spreads can also be divided into other types based on how they are calculated, such as:
Actual spread. The actual difference between the current bid and the ask price of a financial instrument.
Centralized spread. Calculated based on the difference between the bid and ask prices in the main market and the subsidiary market.
Hidden spread. The difference is added to the ask price or subtracted from the bid price and is used in online trading where the bid and ask prices are not displayed in real time.
What affects the spread
There are several factors that can affect trading spreads, including:
The level of liquidity in the market can affect the size of the spread. When liquidity is high, there are many bids and offers available in the market, leading to a decrease in the spread. When liquidity is low, there may be fewer bids and offers available, leading to an increase in the spread.
Sudden economic events can affect the size of the spread, as they can lead to increased price volatility and an increase in the size of the spread.
The financial performance of companies can affect the size of the spread, as good business results can lead to an increase in demand for the company’s shares, leading to a decrease in the spread.
Emerging currencies typically have higher spreads than more commonly traded currencies, as they can be affected by trading volume and liquidity in the market.
Geopolitical factors such as conflicts and political events can affect the size of the spread, as they can increase price volatility and the size of the spread.
Trading volume can affect the size of the spread, as trading with larger volumes can lead to an increase in available bids and offers, leading to a decrease in the spread.
Consider these factors when analyzing the size of the spread and making trading decisions.