When choosing an investment asset, it is important to keep its liquidity in mind. One of its indicators is the exchange spread. Therefore, experienced traders always pay attention to this indicator. Besides, making transactions in the period of its minimum values, it is possible to save significantly. Let’s find out what causes the spread on the stock market and how to work with it.
What affects the spread
The spread is the difference between the best buy price and the best sell price available in the stock market. It is always present on the stock market, regardless of the trading floor and investment instrument. Unlike the spread on the Forex, on the stock market the size of the spread depends solely on the level of supply and demand. The broker has no influence on it.
There is also a concept of “intermarket” spread. It appears if trading is carried out on different platforms by different rules. Example, foreign stocks on the Moscow Exchange. If you recalculate the price from rubles into dollars at the current exchange rate, the figure will not match the world floors and the St. Petersburg Stock Exchange to the cent. Therefore, for an investor who has access to several markets, it is advisable to compare the situation before concluding a transaction.
You can often hear the term “calendar spread”. It is applicable only on the futures market. Under it we understand the divergence of the price for the same contract with different terms. It may be due to objective reasons, such as dividend cutoff, or due to market concerns due to the political situation or economic crisis.
On the exchange, the spread is always floating. This means that the prices of limit orders to buy and sell do not change in parallel.
The first thing that the size of the spread on the stock market indicates is the liquidity of the security. The larger the trading volume, the smaller the difference between sellers’ and buyers’ bids. So it’s preferable to make transactions during the highest activity hours of traders. This is especially evident at the St. Petersburg Exchange. During the period when trades are held on the U.S. exchanges, it is much easier to find a profitable offer.
The spread also serves as an indicator of market expectations and changes under the influence of economic or political news. Most often it rises in anticipation of companies’ reports, regulators’ decisions and so on. This can be explained by the fact that many traders are afraid of acting before the crucial moments. As a result, the trading volume decreases. If you notice that the difference between sellers’ and buyers’ bids has risen sharply, it is not the best time to trade.
How spread is formulated
When you submit a limit order, it is not executed immediately, but goes into the stock market. The same thing happens with the orders of investors who want to make a reverse trade. As a result, a queue of orders is formed. The higher the demand for this asset, the more will be willing to work at the market price. This narrows the spread. If the trading volume of the instrument decreases, it starts to grow.
The difference between the prices of buyers and sellers is also influenced by the presence of a market maker. Among his duties is to keep not only trading activity, but also the spread within acceptable limits. If he leaves the market for any reason, it leads to a sharp increase in the difference between the prices of differently directed bids.
An additional factor is the actions of large bidders. If someone puts up a large bid on the market, he or she temporarily pushes the quotations of the asset up and collects a lot of limit bids from sellers. As a result, the gap between the remaining orders in the cup grows. By waiting this moment, you can find a better price.
To reduce the spread, you need to work with limit orders. This is especially important if you are planning a deal with large volumes and not the most liquid asset. In this case, buying or selling “on the market” can significantly affect the average price. In third-tier stocks or over-the-counter markets, the spread is one of the deciding factors in determining your return.
To sum it up
The stock spread is a phenomenon that all traders have to deal with. For long-term investors working with liquid assets it does not play a decisive role. But if you want to trade unpopular securities or have an intraday strategy, it becomes one of the factors of success. In any case, a large spread is a sign of low trading volumes of an asset. That’s why you should always look at the stock market before you make a brokerage request.
Shon Hill is a major investor and player in the investment market. He is an investment angel for various companies and knows a lot about technical analysis.