Spread
The spread is the difference between the bid price (what buyers are willing to pay) and the ask price (what sellers are willing to accept) for any tradable asset. This gap represents an implicit transaction cost that all investors pay when entering or exiting positions. Understanding spreads is essential for evaluating the true cost of trading.
How the spread works
Every market has two prices at any given moment:
- Bid price: The highest price a buyer is currently willing to pay
- Ask price: The lowest price a seller is currently willing to accept
- Spread: Ask price minus bid price
For example, if a stock shows:
- Bid: $99.50
- Ask: $100.00
- Spread: $0.50
If you buy immediately at the ask ($100.00) and sell immediately at the bid ($99.50), you would lose $0.50 per share—this is the spread's cost.
Simple analogy
Think of the spread like a currency exchange booth at an airport. They buy dollars from you at one rate and sell dollars to you at a higher rate. The difference is their profit margin. Similarly, market makers buy at the bid and sell at the ask, and the spread is their compensation for providing liquidity.
Why spreads exist
Spreads serve several important market functions:
- Market maker compensation: The spread rewards those who provide continuous buy and sell quotes
- Risk premium: Wider spreads compensate for the risk of holding volatile or illiquid assets
- Supply and demand: The gap reflects the current balance between buyers and sellers
- Information asymmetry: Spreads may widen when there is uncertainty about an asset's true value
Factors affecting spread size
Several elements determine how wide or narrow a spread will be:
Narrower spreads typically result from:
- High trading volume and liquidity
- Stable, established assets
- Active market hours
- Competition among market makers
Wider spreads typically result from:
- Low trading volume
- High volatility or uncertainty
- After-hours or pre-market trading
- Exotic or thinly-traded assets
- Breaking news or market stress
Spread examples across markets
Different markets have characteristically different spread sizes:
| Market | Typical Spread | Example |
|---|---|---|
| Major forex pairs | 0.01-0.03% | EUR/USD: 1-3 pips |
| Large-cap stocks | 0.01-0.05% | Apple: $0.01-$0.05 |
| Small-cap stocks | 0.5-2% | Varies widely |
| Major cryptocurrencies | 0.05-0.2% | Bitcoin on major exchanges |
| Altcoins | 1-5%+ | Less liquid tokens |
Types of spreads in investing
The term "spread" applies to several related concepts:
- Bid-ask spread: The core trading spread described above
- Credit spread: Yield difference between corporate and government bonds
- Option spreads: Strategies using multiple option positions
- Yield spread: Difference in yields between different bond types
- Calendar spread: Trading the same asset across different time periods
Hidden cost alert
Spreads are often the largest hidden cost in trading, especially for frequent traders or those dealing in less liquid assets. A 2% spread means you lose 2% the moment you enter a position. Always check the spread before trading, and favor assets and exchanges with tighter spreads when possible.
The spread's impact on returns
For investors, spreads create an immediate hurdle:
- Breakeven requirement: An asset must move by more than the spread just to break even
- Compounding effect: Frequent trading multiplies spread costs
- Long-term drag: Even for buy-and-hold investors, wide spreads at entry and exit reduce returns
Example calculation:
- You buy with a 1% spread and sell with a 1% spread
- Your total spread cost is approximately 2%
- An investment gaining 10% really nets only about 8% after spread costs
Minimizing spread costs
Practical strategies to reduce spread impact:
- Trade liquid assets: Major stocks, ETFs, and popular cryptocurrencies have tighter spreads
- Use limit orders: Set your price rather than accepting the current spread
- Avoid market orders during volatility: Spreads widen dramatically during high-volatility periods
- Trade during market hours: Spreads are narrowest when markets are most active
- Compare venues: Different exchanges may offer different spreads for the same asset
Related terms
- Liquidity: The ease of trading without significantly affecting price—directly impacts spread size
- Market order: An order that executes immediately at current bid/ask prices
- Limit order: An order at a specified price that may help avoid paying the full spread
- Exchange: The marketplace where spreads are determined by supply and demand