Definition
Spread cost is the difference between a financial asset’s bid and ask prices. Such an asset could be a stock, bond, or currency pair. The bid price is the highest price a buyer will pay, while the ask price is the lowest price a seller will accept. The spread cost is the difference between these two prices, and it represents the cost that investors incur when they buy or sell a financial asset.
It applies when selling and buying commodities, bonds, currencies and stocks. This goes to the person or entity facilitating the trade.
The spread can be large or small depending on what is being traded, the time of day the trade is happening, trading activity and economic conditions.
How is it used in the financial sector?
Spread cost is an important consideration for investors, as it can significantly affect the profitability of their trades. For example, if an investor wants to buy a stock with a bid price of £10 and an ask price of £10.10, the spread cost would be £0.10 per share. If the investor buys 1,000 shares, the spread would be £100, which would be added to the total cost of the trade.
Some investors also buy and sell spreads where they bid on whether the spread will increase or decrease in a given period. Doing this is similar to bidding on whether the price of an investment asset or commodity will increase or decrease over time.
Financial institutions, such as banks and brokerages, can also use this as a source of revenue. They can profit by buying assets at the bid price and selling them at the ask price, capturing the spread cost as their profit margin.
What is the relationship between spread cost and liquidity?
Spread cost and liquidity have an inverse relationship where an increase in one leads to a decrease in the other. Liquidity refers to how easy it is to buy or sell an asset without causing its price to change significantly.
Highly liquid currency pairs or assets have high trading volumes and many market participants. As a result, the bid and ask prices for these currency pairs are usually very close together, resulting in a smaller spread for investors who want to trade these pairs. Because of this, the bid and ask prices for these currency pairs are typically very close together, resulting in a smaller spread cost for investors who want to trade these pairs.
On the other hand, less liquid financial assets tend to have larger spreads, as there are fewer buyers and sellers in the market. The bid and ask prices for these assets can be further apart, resulting in a higher spread cost for investors who want to trade them.
How can investors reduce the spread cost?
Investors can reduce their spread cost in various ways. The first one is using limit orders that they can use to avoid paying it altogether or reduce it significantly. This is because limit orders allow traders to enter a trade at a specific price rather than at the market price, which may include a wider spread.
When selecting a broker, traders should look for one that offers lower spreads. Some brokers offer variable spreads, which can change depending on market conditions, while others offer fixed spreads. It’s important to compare the spreads different brokers offer and choose one that suits your trading style and preferences.
The other way is monitoring market volatility. The spread cost can increase during times of high market volatility. Traders can reduce this by monitoring the market and avoiding trading during periods of high volatility.
