The bid-ask spread is a key component in trading markets. This post will cover

• Its definition – representing the difference between the bid price and the ask price.

• Its role in compensating market makers for providing liquidity.

• The distinction between variable and fixed spreads, with guidelines for choosing the right type.

• How to calculate the spread as transaction cost.

What is a Bid-Ask Spread?

The bid-ask spread is the difference between the bid price and the ask price of a financial asset.

• Bid Price (Selling): The bid price is the highest price a broker is willing to pay to buy an asset. Traders can sell the asset to the broker at this price.

• Ask Price (Buying): The ask price is the lowest price at which a broker will sell an asset. Traders can buy the asset from the broker at this price.

Why Is There a Spread?

Bid-ask spread serves as an incentive for market makers which provides market liquidity. We will break down the concepts of market makers and liquidity before illustrating with an example.

• Market Maker: A market maker is a firm or an individual who continually buys and sells assets, ensuring liquidity and facilitating trading. They profit from the bid-ask spread.

• Liquidity: Liquidity refers to the ease with which an asset can be converted into cash without significantly affecting its market price.

Now, let’s consider a simplified example. Imagine a small gold trading market with only two participants – a buyer and a seller.

• Seller’s Perspective: The seller owns a gold bar valued at $1,800 and their minimum acceptable selling price is $1,800.

• Buyer’s Perspective: The buyer is willing to pay up to $1,700 for the gold bar.

• Impasse: Without a middle party, the transaction stalls as neither adjusts their price expectations.

• Market Maker’s Role: A market maker enters the market to bridge the gap. They buy the gold bar from the seller at $1,730, and sell it to the buyer at $1,770.

• Outcome:The seller gets $30 more than the buyer's maximum offer ($1,700), and the buyer pays $30 less than the seller's minimum price ($1,800). The deal is more likely to proceed since both parties benefit from the improved prices. If the deal is done, the market maker will earn the $40 bid-ask spread.

Market makers play a crucial role in ensuring liquidity in the market. They facilitate transactions by offering better prices for buyers and sellers, and they earn their reward from the bid-ask spread. In this example, the spread is $40, which provides the market maker with an incentive to engage in the transaction and keep the market fluid. Without this spread, market makers would have little motivation to provide liquidity, which could stall the market.

Types of Spreads

Generally, brokers charge spread as a fee for acting as intermediaries in transactions. There are two main types of spreads: fixed spreads and variable spreads. Each has its own advantages and disadvantages, making them suitable for different trading styles.

1. Fixed Spreads

Fixed spreads remain constant regardless of market conditions. They are typically offered by brokers operating under a dealing desk technology. With a dealing desk, the broker buys large positions from liquidity providers and offers these positions in smaller sizes to traders, effectively acting as the counterparty to their clients’ trades. By controlling the prices they display, brokers can offer fixed spreads.

Pros of Fixed Spreads:

• Predictable Costs: Fixed spreads allow for accurate planning of trading costs in calm market conditions, making it easier to manage expenses. Fixed spreads are suited for traders who prefer stability in their trading costs.

Cons of Fixed Spreads:

• Re-quotes During Volatility: In volatile markets, the fixed spread can lead to frequent re-quotes because the broker cannot adjust the spread to match rapidly changing market conditions. This can disrupt trades, forcing you to accept a less favorable price or miss the trade entirely.

2. Variable Spreads

Variable spreads, also known as floating spreads, fluctuate in response to market conditions. These spreads are offered by non-dealing desk brokers who source prices from multiple liquidity providers and pass them on to traders without intervention of a dealing desk. As a result, spreads will widen or tighten based on the supply and demand of assets and overall market volatility.

Pros of Variable Spreads:

• Narrow Spreads in Active Markets: Variable spreads tend to be narrow when markets are liquid and active, and in some cases, there may be no spread at all in stable market conditions.

• Transparency: With No Dealing Desk technology, brokers do not control spreads or quotes, ensuring more transparent pricing and eliminating re-quotes.

Cons of Variable Spreads:

• Wider Spreads in Volatile Markets: During periods of high volatility or low liquidity, variable spreads can widen significantly, which may reduce your profits and make it harder to predict transaction costs.

3. Choosing the Right Type of Spread

Understanding the trade-offs is crucial when choosing between fixed and variable spreads. Fixed spreads offer predictability in trading costs but may lead to re-quotes during volatile market conditions. Conversely, variable spreads reduce the likelihood of re-quotes but are less predictable, as they fluctuate with market conditions. Your choice depends on how you prioritize cost predictability versus the flexibility of avoiding re-quotes. Generally speaking,

• Fixed Spreads: Ideal if you value cost predictability in stable market conditions, have a smaller account, or trade less frequently.

• Variable Spreads: Better if you trade frequently, especially during peak market hours when spreads can be tightest, or if you want to avoid re-quotes.

How to Calculate Spreads as Transaction Costs

As mentioned earlier, brokers charge spreads as a form of transaction cost. Since spreads are typically measured in pips, which is the smallest unit of price movement, the actual transaction cost is calculated based on the following factors:

• PIP Value

• Trade Volume/Lot Size

Let’s break this down using an example with the EUR/USD currency pair:

• Bid Price: 1.08160

• Ask Price: 1.08172

The spread is the difference between the bid price and the ask price, which in this case is 1.2 pips (1.08172 - 1.08160).

Example 1: Mini Lot (10,000 Units)

• Scenario: You’re trading one mini lot, which is 10,000 units.

• Value per pip: $1, calculated as 0.0001 (one pip) * 10,000 units (1 mini lot) of base currency.

• Transaction Cost: $1.2, calculated as 1.2 pips (spread) * $1 (value per pip).

Example 2: Standard Lot (100,000 Units)

• Scenario: You’re trading one standard lot, which is 100,000 units.

• Value per pip: $10, calculated as 0.0001 (one pip) * 100,000 units (1 standard lot) of base currency.

• Transaction Cost: $12, calculated as 1.2 pips (spread) * $10 (value per pip).

As you increase your trade volume or lot size, you simply multiply the cost per pip by the number of lots to determine the total transaction cost.

Conclusion

Understanding the bid-ask spread is essential for traders as it directly impacts transaction costs and overall profitability. The spread compensates market makers for providing liquidity, making it possible for buyers and sellers to execute trades more efficiently. Whether opting for fixed or variable spreads, traders should align their choice with their trading style and market conditions. MC Prime offers spread as low as 0, ensuring transparency and competitive pricing in various market conditions. Start trading with MC Prime today and maximize your potential in the financial markets.