Spread is a difference between the ask and bid prices
Sometimes, when analyzing a chart, the spread term means a difference between the high and low of a bar/candle. Spread is a range, expansion and amplitude.
Even a novice can easily see the spread in the trading and analytical ATAS platform with the help of the Depth of Market indicator.
It is a convenient graphical presentation of limit orders at each price level. By default, the bids are green and asks are red.
Let us consider one example. One of your neighbors, William Johnson, wants to buy 10 kilos of potatoes at $1 – this is the bid price. Another neighbor of yours, John Williamson, wants to sell 15 kilos of potatoes at $2 – this is the ask price. The spread between these prices is $1. If William Johnson and John Williamson both would have made a trade-off, they could have executed the trade immediately. But they both use limit orders, they are not in a hurry and do not want to make a trade-off.
The more sellers are there in the market, the more selling orders would be posted by them at a higher level than the market price (the price of the most recent registered buy/sell trade). A competition will grow among sellers and, while trying to sell their goods, they would have to decrease the price of their offers. Thus, the bid prices move closer to the current market price.
And, respectively, the more buyers, the bigger is the number of buying orders in the market and the ask price moves closer to the current market price.
If there are more prices, the liquidity is higher and the spread is narrower. If there are less prices, the liquidity is lower and the spread is wider. Liquidity is a possibility to sell fast with a minimum spread between the bid and ask prices.
A spread is always a bit of a disappointment for a minor trader, since it increases expenditures in trading.
It is like a currency exchange shop – the selling price of any world currency is always higher than the buying price. It is absolutely unprofitable for currency buyers, but very profitable for a currency exchange shop.
Let us assume that the Guinean Franc (GNF) is traded at USD 9.95-10. The bid price is USD 9.95 and the ask price is USD 10. The spread in this case is 5 cents or 0.5% (0.05/10). The buyer who will buy GNF for USD 10 through a market order (at the ask price), would lose 0.5% on this trade due to the spread. Buying GNF 100 would bring USD 5 of losses and GNF 10,000 – USD 500 of losses. Similarly, the seller will have losses when executing a market order at the bid price. It is obvious that a trader should consider the spread influence on the final result in the long run.
Spreads and prices become very ‘active’ during:
- publications of important economic news and statistical data;
- when the market is opened and closed;
- when officials make speeches.
Such events are accompanied with the increase of liquidity. A number of traders is big (for different reasons): the buyers consume the closest asks and the sellers – closets bids. It is believed that trading directly at these moments has a higher risk.
How to reduce expenditures connected with the spread:
- to use limit orders;
- to calculate the size of your order with consideration of the available offsetting orders;
- to trade around narrow spreads, that is in the liquid markets.
