What's the Bid-Ask Spread in Trading?
The bid-ask spread in trading is the difference between the price you can buy an asset (ask) and the price you can sell it (bid). This spread acts as a transaction cost, which is why a trade may show a loss immediately after opening.
The size of the spread depends on market liquidity (how many participants are trading) and market depth (how easily large orders can be processed without changing prices). In more liquid markets like major forex pairs, the spread is smaller, while less liquid assets have larger spreads. Over time, these costs can affect your overall profitability, especially in short-term trading.
What Is the Bid-Ask Spread?
In finance the spread can mean a range of things, but the one we’re talking about for now is particularly relevant for trading and is known as the bid-ask spread.
If you look at the prices on your trading terminal for any asset, there are usually two different prices displayed. One is the bid, and the other is the ask.
Or even more simply put, one is the price you can buy the asset at, while the other is the price you receive when selling the asset. The prices being displayed are chosen because they’re the best prices available for buying or selling at that point in time from the current market participants.
The price to buy is usually higher than the price to sell, if you were to buy and immediately sell without any change in the price of the underlying asset, you actually lose money, due to the difference in the prices.
This can confuse and worry a lot of new traders as they wonder why they are already running a loss the moment they open a trade. It’s because if they were to close the trade immediately, they would lose money due to the spread.
This is actually normal, and is essentially the transaction cost for the trade. This is collected by market makers or brokers to make a revenue from the trading activity that they’re facilitating.
The Size of the Spread
The size of the spread is going to depend on the liquidity and depth of the market. Liquidity refers to how many participants have orders in the market and are willing to transact at any point in time, whereas the depth of the market refers to how able the market is to accommodate a large market order without affecting prices too much.
You’ll usually find that when there is an uncertain event impacting the market, such as a big economic data release, the spreads can start to widen. That’s because the uncertainty of those events causes market participants (particularly market makers) to pull their liquidity to avoid taking on any unnecessary risk.
However, a lot of the retail brokers you’ll be using will offer fixed spreads, so you know exactly what the spread is going to be at any given time, so this may not affect your trading so much.
With retail brokers, the spread for major forex pairs is usually between 0.7 to 3 pips, while less liquid pairs can see much higher spreads. This is the same if you're trading indexes or individual stocks. The spreads for a major blue chip company will be much tighter than a low cap penny stock.
But going back to forex. Let’s say you want to trade EUR/USD, since this is a highly liquid asset, it would usually have a tighter spread. The difference between the buy and sell price is smaller. It’s going to cost a lower amount than a less liquid asset such as CAD/JPY due to a wider spread.
This isn’t such a big problem on longer time-horizons where the price is moving hundreds of pips or more, but if you’re looking to day trade where a move might be just tens of pips, this could become a bit of a deal breaker for you as the spread will account for quite a large percentage of the overall trade.
For example, if you have a spread on EUR/USD of 2 pips and the move you’re trading is a 40 pip move, the spread has effectively cost you 5% of the trade. Whereas if the move is 100 pips, it’s only 2% of the trade. This might not seem a big difference, but it adds up over time.
On the other hand, if your spread is 8 pips, on a 40 pip move it’s 20% of the move, which is a lot more. These transaction costs over time will be negatively impacting your profit or loss to a greater extent.
These transaction costs are something we need to keep in mind when opening trades and when considering which markets are appropriate for the type of trading we want to do. This may mean we need to be more conscious during specific times, such as when there is more volatility around economic news releases or during quieter times in the markets when there is less liquidity. It may even mean that we avoid certain markets altogether.