When engaging in asset transactions on a cryptocurrency exchange and forex trading, market prices are determined by the law of supply and demand. In addition to price, it is essential to consider trading volume, market liquidity, and order types. Remember that market conditions and order types can affect the outcome of a trade. Buyers and sellers engage in ongoing negotiations, leading to a bid-ask spread.
In this article, we are going to learn strategies to take advantage of the spread between bid and ask, calculate potential profits and identify the most favorable options.
What is the bid-ask spread? Detailed explanation
The bid-ask spread is a financial term that refers to the difference between the purchase price and the sale price of an asset available on the market. It reflects the highest value a buyer is willing to invest in the asset and the lowest amount the seller can accept. To understand the dynamics of “supply” and “demand”, two parties must be taken into account: the price taker (trader) and the market maker (counterparty), who shape market trends.
Market makers are agents who may be employees of brokerage firms that offer to buy and sell securities at a fixed price; that is, the purchase price and the sale price, respectively. Investors take either of these prices when entering into a transaction, depending on whether they are buying (buy price) or selling (sell price) the security. The price of a security in the market is exclusive and has its importance at a specific moment.
In financial trading, the spread refers to the difference between the bid and the ask prices of an asset. This difference acts as a transaction cost, which the market maker charges when orders are processed. Usually, brokerage firms indicate that their income comes from traders who “cross the spread.”
The bid-ask spread reflects the balance of supply and demand for a specific asset. The bid price represents demand, while the ask price represents supply. When these prices diverge, it indicates a change in supply and demand.
When buying or selling securities, the difference between the highest bid and lowest ask prices, or the bid-ask spread, can be affected by the depth of market bids and offers. The spread can widen with fewer limit orders to buy or sell. To ensure a successful buy limit order, it is essential to consider the bid-ask spread. Professional traders can widen the spread if they perceive risk in the market. Specific traders try to profit from changes in the bid-ask spread.
How does the bid-ask spread work? Tips to make it more efficient
A bid-ask spread refers to the variation in price between the highest price a buyer will offer (bid price) and the lowest price a seller will accept (ask price) for a security or other asset in the markets. The size of the spread can indicate the level of demand for the asset. Assets with a narrow bid-ask spread are typically in high demand, while those with a wider spread may have lower demand, leading to larger differences in their price.
When buying or selling a security, it is advisable for the investor or trader to use limit orders instead of market orders. Market orders are executed at the current market price, which can sometimes result in a higher price for purchases or a lower price for sales. In contrast, limit orders allow the buyer or seller to set a specific price limit for the transaction.
Let’s look at an example. Let’s assume that the current market price for the security you want to buy is $9.95/$10. Instead of entering a market order and paying $10, you could bid $9.97 using a limit order. Although there is a risk that the price will rise above your offer, you can constantly adjust your offer if necessary. This way you won’t have to buy the shares at a higher price if the market moves against you.
Avoid liquidity charges
Limit orders not only increase liquidity in the market, but also allow you to avoid the liquidity fees that ECNs typically impose for using market liquidity. These charges arise from the execution of market orders at existing bid and ask prices. By using limit orders instead, you can better manage liquidity and avoid unnecessary fees.
Take into account the spread percentages
As we have seen with the example above, bid-ask spreads can have a significant impact when margin or leverage is used. It is essential to evaluate the percentage of the spread, keeping in mind that a spread of 5 cents on a $10 stock is more important in percentage terms than a spread of 5 cents on a $40 stock. To ensure optimal investment results, you must be diligent in evaluating the spread.
Compare prices and find the most convenient one
For retail forex traders, locking in 1 cen
t spreads like interbank and institutional traders do is a rare luxury. It is imperative to look for brokers that offer the tightest spreads within the Forex market aimed at retail clients. So, it’s advisable to read the BlackBull Markets review which may help you increase the chances of trading successfully.
How to calculate the bid-ask spread?
Simply put, the price of a security will rise if more people are interested in buying it than selling it. This is because the demand for security creates a bidding war among buyers, causing the stock price to rise. On the other hand, if more people are selling the security than buying it, supply exceeds demand, forcing sellers to lower their asking price and pushing the stock price down.
That is the place where calculating bid-ask spreads becomes essential. The following examples will help you understand how to do it.
Example 1: The stock’s current trading range is between $9.95 and $10, with the bid price at $9.95 and the ask price at $10. Therefore, the bid-ask spread is 5 cents or 0.50% of the transaction value. It is essential to remember that if a buyer buys the shares at $10 and immediately sells them at the current offer price of $9.95, a 0.50% loss will occur, regardless of the number of shares involved.
Example 2: Assuming a current quote of €1 = $1.3300 / $1.3302, a retail forex trader buys €100,000 on margin. The bid-ask spread is equal to two pips or 0.015% of the traded amount. Understanding the bid-ask spread percentage is necessary as it can significantly affect a trader’s potential profits or losses.
How to benefit from the bid-ask spread?
The concept of liquidity is fundamental in financial markets. If you try to trade in low liquidity markets, you may have to wait for an extended period until your order matches that of another trader.
Liquidity generation is essential. However, not all markets have sufficient liquidity from individual traders alone. In traditional markets, brokers and market makers offer liquidity in exchange for arbitrage profits.
Market makers can exploit the bid-ask spread by buying and selling an asset simultaneously. Market makers can earn the spread as arbitrage profit by repeatedly selling at the higher ask price and buying at the lower bid price. Even a small spread can lead to significant profits if the trading volume is large throughout the day. As market makers compete and narrow the spread, assets with high demand have smaller spreads.
For example, a market maker could offer to buy BNB for $350 per coin and sell BNB for $351 simultaneously, creating a margin of $1. Anyone who wants to trade immediately must comply with the market makers’ positions. Now the spread represents pure arbitrage profits for the market maker, who sells what he buys and buys what he sells.
Conclusion: What is a good bid-ask spread?
In the concept of options trading, it is essential to understand that strike prices further away from the stock price have wider bid-ask spreads. To illustrate this point, we look at closing bid-ask spreads on the S&P 500 ETF, also known as SPY. We focus on early 2022 options with a 60-day expiration window.
Our analysis revealed that in-the-money calls and puts have the widest bid-ask spreads, with deep-in-the-money options having spreads of around $0.50. On the other hand, at-the-money options, with strike prices close to $205, and out-of-the-money options have relatively tight bid-ask spreads. However, it is important to note that the latter have tighter spreads because their option prices are affordable (for example, a $0.05 option cannot have a $0.50 spread).
Therefore, when trading options, it is essential to keep in mind this relationship between bid-ask spreads and strike prices. Don’t hesitate to carefully research and analyze the options market to make well-informed investment decisions.