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Spread

SpreadThe term "spread" has several meanings, but its basic meaning is "the difference".

What Is a Spread?

It has the following meanings:

  • the difference in the prices of two similar products traded on open markets (for example, the difference in the price of different sorts of oil);

  • the difference between the best price for the sale (ask) and the purchase (bid) for an asset (share, commodity, currency, futures, or option);

  • a derivative financial instrument that typically consists of two open positions with the opposite direction and/or different underlying assets and/or different execution dates;

  • the difference in the profitability levels of various financial instruments.

On stock exchanges, the spread is measured in points, not in money. For example, if the current

quotation of the Euro against the US Dollar (EUR/USD) is indicated as 1.2345/1.2350, then the spread will be 0.0005 dollars or 5 points. Measurement in points makes spreads on different trading objects more comparable.

To ensure market liquidity, exchanges typically set the maximum spread. If this limit is exceeded, the trade may stop. The smaller the spread, the more liquid the asset, and vice versa. The size of the spread can also indicate market interest: the more people want to trade with the asset, the smaller the spread.

In bond markets, the meaning of a spread is different - it refers to the difference in yields on similar bonds. For example, if the yield on a US Treasury bond is 6% and that of a UK Government bond is 8%, then the spread is 2%.

Spread Trades

A spread trade occurs when an investor buys and sells two related securities that have been bundled together as a single unit, at the same time. Each transaction in a spread trade is called a leg. The idea behind spread trading is to create a profit from the spread between the two legs, which are typically futures and options.

There are three types of spread trades:

  • Option spreads: buying and selling of the same stock but at different "strike points".

  • Inter-commodity spreads: the relationship between the prices of two comparable but different commodities, e.g. silver and gold.

  • Calendar spreads: expected market performance of an asset on a specific date vs. the asset's performance at another time. For example, January wheat futures vs October wheat futures.

Spread trades allow investors to use market fluctuations to make a profit. Sometimes they are also used as a hedging strategy.

Spread in Forex Trading

In forex trading, the spread is measured in pips, which are the same as points for stock exchange. For most currency pairs, one pip equals 0.0001. There are 2 types of spreads in forex: fixed and variable (floating).

Fixed Spreads

In some cases, when one market operator simultaneously provides both purchase and sale, it forms a fixed spread, which does not change when the quote fluctuates. The more liquid the market, the more frequent the fixed spread. This is most often observed when trading currencies (a fixed difference between the purchase and sale prices of currencies), especially with intermediaries in the international currency market. In the stock market, a fixed spread is found in margin trading with CFD contracts.

Fixed Spreads are offered by brokers that operate as a market maker or "dealing desk" model. The broker uses a dealing desk to buy positions from their liquidity providers in big amounts and offers those positions in smaller amounts to traders. A dealing desk allows the broker to offer Fixed Spreads because they gain control over the prices that they show their clients.

Fixed Spreads have smaller capital requirements, so trading is a cheaper alternative for traders with a limited budget. FS trading also makes the calculation of transaction costs more predictable. Spreads never change, so you always know what you can expect to pay when you open a trade. However, because the pricing is coming from just one source - your broker - they will not be able to widen the spread to adjust it for changing conditions in volatile markets. So if you try to enter a trade at a specific price, the broker will "block" the trade and ask you to accept a new price.

Another issue is slippage. When prices are moving fast, the broker cannot consistently maintain an FS and the price that you finally get after entering a trade will differ from the initial entry price.

Variable Spreads

With variable spreads, the difference between the bid and ask prices of currency pairs is constantly changing. Variable spreads are offered by non-dealing desk brokers. Such brokers get their pricing of currency pairs from several liquidity providers and pass on these prices to the trader without a dealing desk, thus having no control over the spreads. As a result, the spreads are impacted based on the supply and demand of currencies and the overall market volatility.

With variable spreads, you will not experience any requotes. Trading with variable spreads also ensures more transparent pricing.

Why the Bid-Ask Spread Is Important

It is crucial to remember the key aspect of the bid and ask prices: purchasers pay the ask price and sellers get the bid price. That's how securities dealers make a profit on bid-ask spreads. They buy stocks at the bid price and sell them at the ask price. Thus, the greater the bid-ask spread, the greater the dealer's profit.

Many traders observe the patterns in bid-ask spreads to understand what prices trigger demand for both sellers and buyers. However, it is also believed that it is quite difficult to predict the bid-ask spread.

Summary

A spread commonly means a difference between certain prices, such as the bid and ask price. The smaller the spread, the more liquid the asset, and vice versa. In forex trading, there are two types of spreads: fixed and variable. Each of them has its own benefits. For example, fixed spreads have lower capital requirements whereas variable spreads ensure greater transparency in pricing.