What is a Spread in Trading? – Beginners Guide

When you step into the world of trading, you’ll often come across the term “spread.” For beginners, understanding what a spread is and how it impacts your trading decisions is crucial. In simple terms, the spread is the difference between the buying price (bid) and the selling price (ask) of a financial instrument. Whether you are trading forex, stocks, or commodities, the concept of a spread remains relevant across different markets.

The Basics of Spread in Trading

The spread acts as a cost of trading and plays a significant role in determining your profits or losses. When you place a trade, you buy at the higher ask price and sell at the lower bid price. The difference between these two prices is the spread. The wider the spread, the higher the cost of the trade. Conversely, a narrow spread means lower trading costs. It’s important to note that spreads can vary based on market conditions, liquidity, and the type of broker you use.

Types of Spreads

Spreads come in two main types: fixed and variable. Understanding the differences between these two types can help you make informed trading decisions.

• Fixed Spreads: Fixed spreads remain constant, regardless of market volatility. This type of spread is often favored by traders who prefer consistency in their trading costs. Fixed spreads are commonly offered by market maker brokers who control the prices and spreads they offer.
• Variable Spreads: Variable spreads fluctuate depending on market conditions. When the market is highly volatile, spreads tend to widen. Conversely, during periods of low volatility, spreads narrow. Variable spreads are typically offered by ECN (Electronic Communication Network) brokers who pass on the spreads directly from the market.

Factors Influencing Spreads

Several factors influence the size of a spread, and understanding these can help you choose the right trading opportunities.

• Liquidity: In highly liquid markets, where there is a large volume of trades, spreads tend to be narrower. This is because there are many buyers and sellers, leading to tighter bid-ask prices. Conversely, in less liquid markets, spreads can widen significantly due to the lower number of participants.
• Volatility: During times of high market volatility, such as economic announcements or political events, spreads can widen. This is because brokers anticipate greater risk during these periods, leading to an increase in the cost of trading.
• Time of Day: The time of day can also impact spreads. For instance, during major trading sessions like the London or New York sessions, spreads tend to be narrower due to higher trading activity. Conversely, during off-peak hours, spreads may widen as trading activity slows down.
• Broker Type: The type of broker you use can also affect the spreads you experience. Market maker brokers may offer fixed spreads, while ECN brokers usually offer variable spreads.

Spread Calculation

Understanding how spreads are calculated is key to managing your trading costs. Let’s break down the process with a simple example.

Suppose you’re trading the EUR/USD currency pair. The bid price is 1.1000, and the ask price is 1.1002. The spread in this case is the difference between the bid and ask prices, which is 0.0002 or 2 pips. In forex trading, spreads are often measured in pips, which is the smallest price movement in a currency pair.

Impact of Spread on Your Trades

The spread can have a direct impact on your trading outcomes. When you enter a trade, you start at a slight loss because you have to cover the spread. For example, if you buy a currency pair with a spread of 2 pips, the market price needs to move at least 2 pips in your favor for you to break even. This is why lower spreads are generally more favorable for traders, especially those who make frequent trades or scalp the market.

Spread in Different Markets

While the concept of a spread is consistent across different markets, the way it is applied can vary.

• Forex Market: In forex trading, spreads are typically measured in pips. Major currency pairs like EUR/USD or GBP/USD often have lower spreads due to high liquidity.
• Stock Market: In the stock market, spreads are calculated in absolute terms, such as dollars or cents. Highly liquid stocks like those in the S&P 500 index usually have lower spreads.
• Commodities Market: In commodities trading, spreads can vary widely depending on the asset being traded. For instance, spreads on gold might be narrower than those on less-traded commodities like coffee.

 How to Manage Spread Costs?

Managing spread costs is essential for maximizing your trading profits. Here are some strategies to help you reduce the impact of spreads on your trades:

• Choose the Right Broker: It is crucial to select a broker that offers competitive spreads on the instruments you trade. Compare different brokers and choose one that offers low spreads.
• Trade During Major Sessions: Trading during major market sessions can help you access narrower spreads due to higher liquidity. For forex traders, the London and New York sessions are particularly favorable.
• Avoid Trading During High Volatility: High volatility can lead to wider spreads, increasing your trading costs. If possible, avoid trading during major news events or economic announcements.
• Use Limit Orders: Instead of using market orders, consider using limit orders. This allows you to set your desired entry price, potentially reducing the impact of the spread.

Spread Betting vs. Traditional Trading

Spread betting is a popular alternative to traditional trading, especially in the UK. Unlike traditional trading, where you buy and sell actual assets, spread betting involves speculating on the price movements of an asset. Here’s how it works:

• No Ownership of Assets: In spread betting, you don’t own the underlying asset. Instead, you bet on whether the price of the asset will rise or fall.
• Leverage: Spread betting often involves leverage, allowing you to control a large position with a small amount of capital. However, this also increases your risk.
• Tax Benefits: In some countries, profits from spread betting are tax-free. This is because spread betting is considered a form of gambling rather than investing.
• No Commissions: Spread betting typically doesn’t involve commissions, as brokers make their money through the spread.

Common Mistakes When Trading with Spreads

When trading with spreads, beginners often make mistakes that can impact their profitability. Being aware of these pitfalls can help you avoid them:

• Ignoring the Spread: Some traders focus solely on price movements and ignore the spread. However, failing to account for the spread can lead to unexpected losses.
• Trading During Low Liquidity: Trading during off-peak hours or in less liquid markets can result in wider spreads, increasing your trading costs.
• Overtrading: Making too many trades can lead to higher cumulative spread costs, which can eat into your profits.
• Not Understanding the Spread Type: Not knowing whether your broker offers fixed or variable spreads can lead to confusion, especially during times of high volatility.

 Conclusion

Understanding what a spread is and how it affects your trading is fundamental for any trader. The spread is a cost that you must account for when entering and exiting trades. By choosing the right broker, trading at optimal times, and managing your trades wisely, you can minimize the impact of spreads on your trading performance. Remember, in the world of trading, every pip or cent counts, so being mindful of the spread is key to your success.