Why Do Bid-Ask Spread Matter in Trading? September 11, 2023
Why Do Bid-Ask Spread Matter in Trading?
The bid-ask spread is the difference between the bid and ask price for a given trading instrument. The bid price represents the highest price a buyer is willing to pay for the instrument, while the ask price represents the lowest price a seller is willing to accept. There are many ways an investor can interpret what a bid-ask spread represents for the instrument, including:
- Barometer of Liquidity: a smaller spread suggests higher liquidity, meaning more buyers and sellers are willing to negotiate in the market.
- Trading Risk: a wide bid-ask spread presents greater risk of not trading the instrument at the best prices possible.
- Guide to Type of Order to be placed: normally, if the bid-ask spreads are narrow, you can get the best price with the market order itself. However, if the spreads are wider, then a limit order will be a better choice.
- Direction or Momentum of the market: narrowing and widening of the bid-ask spread is an indication of the direction or momentum of the market movement.
Over-the-counter trading, or OTC trading, refers to a trade that is not made on a formal exchange. Instead, most OTC trades are between the investor and his broker. The broker is therefore termed as the “principal” to the trade. The most popular OTC market is forex (i.e. foreign exchange), where currencies are bought and sold via a network of banks. Forex trading is decentralised and can take place 24 hours a day, as opposed to an exchange’s open and close timing restrictions. With the broker acting as the principal, it is therefore important to understand that both the bid and ask prices are determined by the broker, a process often referred to as “market-making”. The prices determined are often based on two components, namely, (1) what the broker is able to hedge their risk at; and (2) markups. This is also why OTC products can be offered at zero commissions as the intended commissions are represented as markups in prices.
So what do these mean for you?
A bid-ask spread primarily represents transactional cost to an investor. Why is this so? When you enter a trade, you will eventually need to exit. The turnaround costs to an investor would therefore be buying at the ask price (where a seller is willing to sell), and selling at the bid price (where a buyer is willing to buy), even without any changes to the asset’s price. Just on this transactional operation, the investor would have incurred a cost based on how wide the bid-ask spread is.
The bid-ask spread is therefore important as an investor would not want the erosion of profits by high trading costs. Furthermore, when investors uses stop-loss type orders, they should have the assurance that the prices provided by their brokers are competitive (i.e. not a wide bid-ask spread) at least 90% of the time to prevent large slippages.
Example of how transactional costs are calculated through a forex bid-ask spread
Not surprisingly, across various trading instruments, trading forex incurs one of the least transactional costs due to its extremely competitive bid-ask spread. The forex market also offers one of the highest leverage levels among all forms of investing. Therefore, adding forex into your portfolio (either for hedging or speculative purposes), is at a fraction of capital requirement and at very low transactional costs.
Screenshot for illustrative purposes on typical spreads provided by PhillipCapital’s POEMS platform
It is also important to choose the right broker as the counterparty and “market-maker” to your trades. It is essential to understand if your broker is providing these at zero commission with no financing charges, no platform fees, and no added market data fees.
In conclusion, it is important to understand the transactional cost involved in the trading instrument of your choice. The bid-ask spread can also be representative of how competitive your broker is.
PhillipCapital offers a wide range of forex (FX) CFDs to trade from, allowing traders to diversify their portfolio with the forex market. You can find the list of FX CFD currency pairs available here
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About the author
Head of FX CFD
Kenneth Tan graduated from Nanyang Business School with a Master of Science in Financial Engineering. Having worked as a spot and NDF trader for a top bank in Japan and an option dealer with one of France's top five banking groups, Kenneth has devoted more than 15 years to developing the FX business and strongly believes that investing in FX instruments is essential to every investor. He enjoys learning about how automated strategies can enhance trading experience for clients.