Definition and explanations about the spread

If you are interested in online trading, there are certain concepts that you absolutely must know and master, among which is the spread. Indeed, you will always be confronted with this term when you take positions on an asset on a trading platform and you must therefore know what it corresponds to in order to take it into account when implementing your strategies. In this article, we will explain this concept in detail.  

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Definition and explanations about the spread

The spread: What is it?

First of all, let's give you a precise definition of what a spread is. In the world of finance, the spread is actually the difference between the best purchase price of a security, known as the "ask" price, and the best sale price, known as the "bid" price. The spread is therefore a price range.

To help you better understand the spread concept, let's apply it to a concrete example. Let's say you are trading a stock on the stock market using CFDs. You will notice that the stock is listed with two values, for example, $27.90/$27.91. Here, the difference between these two prices, i.e. €0.01, is the spread.

More specifically, the value of a spread will automatically vary from one instrument to another. Moreover, the spread is an element that will evolve over time and vary according to certain factors. It can therefore be more or less important. However, the spread can never be less than the quotation interval of the financial instrument or security concerned, i.e. the minimum variation between two consecutive prices.

 

How is a spread calculated and determined?

To calculate a spread, brokers use different criteria, the main ones being

  • First of all, it will take into account the liquidity. By liquidity we mean the volume of trading in the security concerned. The higher the liquidity, the lower the spread. This is because the number of buyers is high and therefore the number of orders is higher. As a result, the spread between the best selling price and the best buying price will tend to be lower. In fact, in a very liquid market, the spread is often equivalent to the price step under normal market conditions. Conversely, an asset with low liquidity will often be associated with a high spread.
  • Another element to take into account when calculating the spread is the free float, i.e. the number of shares traded on the market. The greater the number of shares in circulation, the greater the number of trades. Here again, this will undoubtedly lead to a lower spread and vice versa when the free float is low.
  • Volatility is also an important point in determining the spread. The higher the volatility of an asset, the higher the spread. This is because sudden changes make it difficult for buyers and sellers to take positions.
  • Finally, the last element taken into account in the calculation of the spread is the interest of investors in the asset concerned. The more popular or popular an asset is with traders, the more buyers and sellers there will be, which will have a positive impact on the spread, which will tend to fall.

 

What is the purpose of the spread for the broker?

It is important to understand here that when you trade on an online CFD trading platform, it is the spread that allows the broker or dealer to generate a large part of their compensation. This is especially true for CFD platforms and Forex brokers. Here, the broker will act on the spread by moving it away from the market in order to generate his compensation on each position taken by the traders.

As such, the market spread is different from the broker's spread. The broker's spread will be slightly wider than the market spread. The spread here represents the consideration you have to pay for the opportunity to trade CFDs or currency pairs, to access organized markets such as futures or equities and to use their services in general. While the spread is usually the only cost that your trades will generate, some brokers charge their clients an additional fee on each trade.

It should also be noted that with certain types of brokers such as futures brokers, the spread displayed is systematically the market spread and does not represent a means of remuneration. Indeed, these brokers operate solely by charging commissions on transactions.

The spread is paid systematically when you take a position. It is only paid once to the broker because if you close your position immediately after it has been opened, the selling price will be the buying price minus the spread.

 

Difference between fixed and variable spread :

Depending on the broker you choose, the spread on certain stocks may be fixed or variable.

The fixed spread is generally higher than the variable spread but has the advantage of not changing according to market conditions. It is therefore better suited to money management, especially for novice traders who can know in advance the cost of their transaction. Moreover, when the market is very volatile, it represents a security. However, more experienced traders often prefer variable spreads, which are lower and allow for lower transaction costs.

The variable spread evolves over time according to supply and demand but is generally lower than the fixed spread. In most cases, the variable spread increases as market volatility increases but remains more competitive than the fixed spread. In general, we recommend that you exercise caution when using a variable spread as it can rise very quickly and affect your gains or losses, especially if you are considering a short-term trading strategy.

 

How does the spread impact your trading strategy?

It is important to understand how the spread influences your investment strategy. When you open a position in the market, you immediately lose out because of the spread. In order to make up for this loss, the security you are trading must move in the right direction by an amount greater than the spread. Only after this spread has been reached will you be able to make any profits.

It is thus obvious that the lowest spreads are those that allow you to get out of this loss the fastest and switch to a winning strategy. Thus, if you prefer short strategies such as scalping, you must absolutely prefer the lowest spreads. Of course and as we have seen above, you will also have to pay attention to other fees and commissions that may be charged by your broker. It is therefore important to pay close attention to the trading conditions that are offered by the different brokers.

Frequently Asked Questions

How to measure the spread?

To measure the cost of the spread on your trade, you need to look at your opening position. Indeed, the spread is always cashed at this time by the broker and therefore, your position will start in negative. It is precisely this negative amount that represents the cost of your transaction. Of course, you can know and calculate this spread in advance by making a simple subtraction between the posted ask and bid.

What strategies are suitable for a high spread?

As we have seen in this article, a high spread will require the trader to wait for a larger price movement to start generating gains. Therefore, a high spread may not be well suited to a short term strategy. However, hedging strategies or other long strategies will lend themselves well to the use of a fixed spread even if it is large and nothing prevents you from choosing an asset and a broker with a high spread.

What is special about the spread in CFD trading?

The spread applied to CFDs has a number of specificities compared to the way brokers are remunerated on other financial instruments such as futures or options. Indeed, the spread represents an all-inclusive service and the investor should not expect any additional fees. Indeed, other more traditional brokers charge additional fees such as entry fees, order placement fees or even market exit fees, which can greatly increase the bill and thus reduce the possibility of gains for traders.

77% of retail CFD accounts lose money. You should consider whether you can afford to take the high risk of losing your money. This is an advert for trading CFDs on Plus500