What it means
Every traded asset has two prices at any moment: the highest price a buyer will pay, called the bid, and the lowest price a seller will accept, called the ask. The difference between the two is the spread.
A spread indicator displays that difference, either in price terms, such as $0.20, or as a percentage of the price. Many trading platforms show it as a live number or plot it on a chart so the trader can see how it changes during the day.
A sudden jump in the number is often the first sign that conditions in the market are changing. The spread matters because it is a cost that you pay every time you trade.
If you buy at the ask and immediately sell at the bid, you lose the spread, so the price has to move in your favour by at least that amount before you break even. Spreads also tell you about liquidity, which is how easily an asset can be bought or sold without moving the price.
This is why a spread indicator is often the first thing checked when a trader looks at an unfamiliar asset. Popular, heavily traded assets typically have narrow spreads, while thinly traded ones have wide spreads.
Spreads are not constant. They tend to widen at times of uncertainty, such as just before major news releases or during sharp market falls, and in the early and late parts of the trading day when fewer participants are active.
The word spread has other meanings in finance, such as the gap between yields on two bonds. A spread indicator in the context of trading screens usually refers to the bid-ask gap, but it is worth checking which spread a particular tool is showing.
In practice
Real-world examples.
Example
A day trader checks the spread indicator before buying a share and sees it has widened from $0.02 to $0.15. She decides to wait until it narrows, as the extra cost would wipe out her expected gain. Checking takes only a few seconds and can save real money.
Example
A corporate treasurer comparing two currency providers notes that one shows a spread twice as wide as the other. He moves a large payment to the cheaper provider and saves several hundred dollars.
Example
A fund manager planning to sell a large holding in a small company sees a persistently wide spread. She breaks the sale into smaller orders over several days to avoid pushing the price down.
Formula
Calculation
Spread (%) = (ask - bid) / midpoint x 100, where midpoint = (ask + bid) / 2
A share has a bid of $49.90 and an ask of $50.10. The spread is 50.10 - 49.90 = $0.20. The midpoint is (50.10 + 49.90) / 2 = $50.00, so the percentage spread is 0.20 / 50.00 x 100 = 0.40%. Buying and immediately selling 10,000 shares would cost 0.20 x 10,000 = $2,000 in spread.Case study
Seen in the real world.
Orchard Capital is an illustrative, fictional small investment firm that trades a portfolio of lightly traded shares. Its junior analyst noticed that the firm's spread indicator showed an average spread of 1.2% on one holding, compared with 0.1% on others.
On a $500,000 position, a 1.2% spread meant a round-trip cost of about 500,000 x 0.012 = $6,000, compared with only $500 at a 0.1% spread. The firm reviewed the holding and decided that its expected return no longer justified the trading cost, so it sold the position gradually over several weeks.
The illustrative lesson is that a spread indicator turns a hidden cost into a visible number. Orchard added spread checks to its pre-trade procedure. Traders must now record the quoted spread and the expected cost before every order above $100,000, and explain any trade where the spread is above 0.5%.
Watch out
Common mistakes.
- Ignoring the spread when estimating the return from a trade, which overstates the profit.
- Assuming the spread is fixed, when it can widen sharply during volatile periods.
- Confusing a trading screen's spread indicator with a bond yield spread, which measures something different.
Questions
People also ask.
What is a good spread?
There is no universal figure, but narrower is better, and heavily traded assets typically have spreads of a small fraction of a per cent while illiquid ones can have far larger gaps.
Why do spreads widen?
Market makers, who quote prices, widen their quotes when they face more risk or have less information, such as around major announcements.
Does the spread cost me money if I hold for a long time?
You pay it once on entry and once on exit, so a long holding period spreads the cost over a longer time and makes it less important.
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