In trading across financial markets, investors encounter various asset prices, such as buying and selling prices, contracts with different expiration dates, and so on. Beyond their absolute values, the difference between these prices plays a crucial role. This discrepancy is referred to in a trader’s lexicon as “spread.”
What exactly is spread in exchange trading, its types, and its impacts? Find the answers to these questions in the article below.
Understanding Spread in Simple Terms
In economics and finance, the term “spread” denotes the difference between two values of a characteristic or homogeneous but differing indicators. Most commonly, it is used concerning prices. Simply put, spread refers to the price difference of an asset or nearly identical goods. For example, spread indicates the difference in prices between:
- Buying and selling stocks;
- Gold prices today versus a week later;
- Various grades of oil such as Brent and WTI, and so forth.
In exchange trading, several types of spreads are considered, usually specified according to their context. For instance, in futures markets, traders often use calendar spreads, while comparing profits from different strategies is referred to as yield spread. A significant indicator for markets and the economy overall is the yield spread demonstrated by bonds (typically government bonds) with different durations – short-term and long-term.
Only one type of spread exists without additional definitions. It is referred to as the Bid-Ask Spread and represents the difference between the best buying and selling prices at a specific moment in trading.
Exchange Spread
The formation of a spread on exchange platforms can be observed in trading terminals. Within these terminals, traders have access to a price ladder – a list of active limit orders for buying and selling assets, along with their prices and volumes. These orders are placed in different halves of the table (ladder): sell orders in ascending order of price, buy orders in descending order. As a result, the order with the best ask price is placed in the lower row of one half of the table, while the best bid price is placed in the upper row of the other half. These rows are adjacent, allowing traders to clearly see the difference between the prices listed in them – the spread.
Types of Spreads
In the practice of trading on financial markets, several types of spreads are distinguished. Apart from the bid-ask spread, professional traders and investors operate with concepts such as:
- Intermarket spread – the price difference of the same asset on different exchange platforms. Its magnitude is crucial for traders employing arbitrage strategies.
- Intramarket spread – the price difference of related, very close, or deeply correlated assets on a single trading platform. Examples include the difference in prices between WTI and Brent oil or between common and preferred shares of the same issuer.
- Calendar spread – a subtype of intramarket spread found in the futures market, reflecting the price difference of contracts for the same underlying asset but with different expiration dates.
- Market spread (buy and sell) – arises when a market participant executes a trade with a market order. It indicates the difference between the market price and the best seller’s (buy spread) or buyer’s (sell spread) price.
In exchange trading, where the asset price is determined through a free auction process, participants deal with a floating spread. This means that the price difference can change depending on market conditions, as traders set prices in their orders at their discretion. The minimum spread cannot be less than 1 point; otherwise, orders are executed. The maximum spread is limited by both the trading platform, which sets an allowable limit, and the actions of market makers.
In the retail Forex market, a fixed spread is often encountered, reflecting the pricing specifics. Dealers receive indicative average quotes from the electronic trading system of the interbank market. These quotes typically do not include bid and ask prices, so the dealer determines the difference between the ask and bid based on their interests (the spread is one of the components of their direct income).
Unlike this market, the currency spread on exchange platforms is also floating. It is floating in banks as well, but it is not related to market pricing. Banks use the official exchange rate established by the Central Bank as the base and set the buying/selling price based on their profit considerations, but within an acceptable range.
Measuring the Spread
Since the spread represents the price difference, it would be logical to calculate (measure) it in the currency units in which the assets are traded. However, using this method in trading is inconvenient because it complicates the comparison of assets. Therefore, in exchange trading, the spread is more commonly measured in points. This method is also imperfect but has become traditional. It is not always convenient to use it to compare asset prices.
When to Consider the Spread in Trading?
The spread is a direct loss for a trading participant who executes a market order. That is, by opening a position with a market order, such an investor immediately incurs a loss equal to the spread.
For investors expecting significant returns and intending to hold positions for an extended period, the spread size plays a secondary role. However, this only applies to liquid market instruments. Those planning to work with illiquid assets (such as third-tier stocks) should consider its size when executing trades. Indeed, if the spread is 2%, and the price increase yield of the stock is 5%, then the resulting real yield will be only 3%.
The spread should also be considered by those whose trading systems are designed for small profits per trade. This includes, for example, scalping and HFT trading. Adjustments for the spread are necessary when setting StopLoss and TakeProfit orders.
To eliminate the impact of the spread, experienced traders work not with market orders but exclusively with limit orders.
Thus, the spread, as the price difference, is one of the important characteristics of the trading process. It allows for assessing the liquidity of an asset and directly influences the magnitude of profit.