Bid-Ask Spread explained: What Traders Need to Know
14 August 2023
The bid-ask spread is the difference between the highest price a buyer is willing to pay for an asset (the bid) and the lowest price a seller is willing to accept to sell it (the ask or offer).
This spread is a fundamental element of market liquidity and represents the transaction cost that traders need to consider when entering and exiting positions. For example, if there is a spread of 1 pip between buyers and sellers, this represented the cost of trade taken.
It is worth pointing out at this stage the much is made of the “spread” in comparison between the value that one broker may offer versus another.
However, there are far more influential factors that determine the success or otherwise of trading such as determining high probability entries, effective risk management and appropriate profit taking exits. This is particularly the case for retail investors who trade smaller contract sizes, as opposed to institutional traders, who often trade much larger sizes of trade ad so small differences in spread will have more impact.
Nevertheless, some understanding of the bid/ask spread, and how this may alter at various points during the trading day is important.
Factors influencing bid-ask spread
Although there are more, we have focused on the top eight factors we think are of not only most influential but have trader relevance.
- Asset Liquidity: A highly liquid market usually has a smaller bid-ask spread. When there are more market participants interested in trading a specific asset, there are more bids and asks available, which narrows the spread. In essence, the abundance of buyers and sellers in a liquid market reduces the difference between the buying and selling prices.
- Trading Volume: Similar to liquidity, higher trading volume often leads to a narrower spread. Increased trading activity means more frequent transactions, which can reduce the spread. Active markets tend to have more competitive pricing due to the large number of transactions taking place.
- Asset Volatility: Increased volatility usually results in a wider spread. When an asset’s price exhibits rapid and unpredictable movements, market makers and traders face higher risk. To compensate for this risk, they set wider spreads. This is often observed when major economic data or news is released, causing abrupt market movements.
- Market Hours: Spreads might be wider during market open and close due to uncertainty and reduced liquidity. This phenomenon is often seen toward the end of market hours and the beginning of new trading sessions. Additionally, some assets may have wider spreads when traded outside their primary market hours, such as futures contracts associated with indexes that are closed during specific times.
- Asset Popularity: Well-known assets usually have tighter spreads compared to less popular instruments. For example, in the Forex market, currency pairs are categorised by liquidity. Major pairs like EUR/USD tend to have tighter spreads because they are highly popular among traders. Exotic pairs, on the other hand, have wider spreads due to their lower trading activity e.g., US Dollar/Polish Zloty (USDPLN)
- Regulatory Environment: The level of regulation in a market can influence the spread. Forex markets, for instance, are less regulated compared to stock markets with centralized exchanges. This can lead to comparatively wider spreads in forex trading, as there is no central authority to standardize pricing.
- Transaction Size: Large orders can impact the spread, making it wider, especially in less liquid markets. When a trader places a substantial order, it can temporarily disrupt the supply and demand balance in the market, causing a wider spread until the order is executed.
- Technological Factors: Faster trading systems and networks can lead to tighter spreads. Advanced technology allows for more efficient matching of buyers and sellers, reducing the spread. High-frequency trading and electronic communication networks (ECNs) contribute to this efficiency by facilitating quicker trade executions.
Other factors to consider with the bid-ask spread
- Slippage and Spread:
A significant aspect to consider in trading is slippage, which refers to the difference between the expected price of a trade and the actual price at which it is executed. A wider spread, indicating a larger gap between the bid and ask prices, can increase the risk of slippage. This happens because, in volatile markets or with wider spreads, it becomes more challenging to execute trades at the precise desired price. Traders may experience slippage when their orders are filled at a different, often less favourable, price due to market fluctuations. Therefore, traders should be acutely aware of the potential impact of spread size on the likelihood and extent of slippage, especially when trading in fast-moving markets.
- Stop Placement and Spread:
As spreads widen, it’s crucial to consider their influence on stop-loss orders. Stop-loss orders are designed to limit potential losses by automatically triggering a trade closure when the asset’s price reaches a specified level. However, an increasingly wider spread introduces the possibility that the spread alone could trigger the stop-loss order. This is particularly relevant when the stop level is set close to the current market price or price has moved towards the stop.
Traders need to strike a balance between setting stop levels that provide adequate protection and avoiding premature triggering due to spread fluctuations. Having a good understanding of the typical range of spreads for the assets they are trading can help traders make more informed decisions when placing stop orders to manage risk effectively.
Alternative accounts and differing spreads
Some brokers offer different types of platforms that may offer tighter than the spread associated with a standard account. Often, there is a small brokerage payable for such accounts and the trader must decide which is the best option for them.
If you are interested in looking at different account types with different spread at GO Markets then drop our support team an email at firstname.lastname@example.org and we would be delighted to walk you through the options that are available to you.
Understanding the bid-ask spread is important for traders as it has the potential to affect many aspects of trading including costs, strategy, risk management, and perhaps even market interpretation.
Although there are significantly more influential factors on your potential trading outcomes than the width of the spread, if treating your trading as a business, which arguably is the right approach to have, then knowing about such factors and their impact would seem prudent.
Disclaimer: Articles are from GO Markets analysts and contributors and are based on their independent analysis or personal experiences. Views, opinions or trading styles expressed are their own, and should not be taken as either representative of or shared by GO Markets. Advice, if any, is of a ‘general’ nature and not based on your personal objectives, financial situation or needs. Consider how appropriate the advice, if any, is to your objectives, financial situation and needs, before acting on the advice. If the advice relates to acquiring a particular financial product, you should obtain and consider the Product Disclosure Statement (PDS) and Financial Services Guide (FSG) for that product before making any decisions.
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