Ever notice how we don’t always get the price we want? It is either a bit higher or a bit lower than the prices we set. Let’s say that you want to buy at the price of 1.25254; however, the price you enter the market is at 1.25301 instead. Encountering a price that’s slightly different from your desired target is what we call the concept of “spread.”
So what is spread?
As mentioned last time, spread refers to the difference between the bid price (the highest price the buyer is willing to pay) and the asking price (the lowest price the seller is willing to accept) for any underlying assets.
As shown below, we as a price taker (individual investors) will buy the underlying assets at the ask prices while selling them at the bid prices, and vice versa for the market maker. So what happens when the spread is too big? The simple answer: you will get the price that you don’t want and possibly pose a threat to your pricing action and profitability.
There are various factors that could potentially lead to widening the spread, such as:
Market Volatility: factors such as uncertainty in economic conditions, intervention from the central bank and government, and geopolitical tension that forces fear in the investor are the main contributions.
- Uncertainty in economic conditions: this can be seen through softening in economic growth, high inflation, or weakening in the labor market—high unemployment rate.
- Central Bank: If the central bank believes that the economy is overheating, then it will increase the interest rate, which causes volatility in the market. And the opposite for lowering the interest rate.
- Geopolitical Event or Unexpected News: Political or diplomatic tensions, such as trade competition, would also result in high volatility in the market.
Low Liquidity: as the markets are left out, that could lead to low liquidity in the market, making the spread widen even further.
Market Maker Behavior: Some markets intentionally widen the spread aiming to increase the profit.
Technological errors, such as slippages that result from malfunctions, can disrupt trading activities.
What happens when the spread widens?
- Increased trading costs and reduced profitability: The wider the spread, the higher the transaction costs will be. This directly impacts profitability, discouraging trading activities.
- While widening spreads can contribute to less favorable trading environments, there are other primary factors contributing to widespread selloff, such as economic downturns, geopolitical tensions, or market corrections. Widespread selloff: an act of large numbers of investors selling their assets, such as stocks, bonds, or commodities. In fact, this is mostly seen at the end of the year, when key players take the profits gained out of the market or cash holding until the next direction.
