TRADING BASICS

Courtesy of DailyFX.com

Spread: The Fundamental Cost of the Trade

The difference between the price you at buy at (also known as the ask) and the price you sell at (also known as the bid).

In all traded instruments - stocks, bonds, futures, commodities, foreign exchange, etc. - there is what is known as a spread. The spread is the required cost of the trade; it is the cost imposed by the party that actually executes your trade. The more directly you interact with the party that executes your trade, the lower your cost will be.

Unlike more commonly recognized financial service charges, like commissions, the spread is not a fixed dollar cost market participants pay. Instead, a spread requires the creation of two prices by the firm you are trading with: the price you buy at, and the price you sell at. The firm that executes your trade will buy at one price, and sell to you at another price. Thus, if you wanted to buy a position and sell right away, you would have to sell at a lower price, since you have to sell at the sell price (which is lower than the buy price). This essentially creates a scenario in which the price of the product you are speculating on must rise by a certain amount before you can close your position, as the sell price must rise enough so that it is equal to the buy price that you bought at if you wish to at least break even.

Thus if a buyer bought at 50 and wanted to sell right away, he/she would have to sell at 45. In this example, the rate needs to move up 5 pips - meaning the quote would be 55-50 -- before the buyer can break even by selling at the sell rate of 50. Clearly, the spread is the cost of the trade: the rate moved 5 pips, but the client's net P/L at that point was still zero.

Historically speaking, most individual traders have not been able to "see" the spread when they are trading. Instead, they are given only one quote: the price they can buy at, or, if they are selling, the price they can sell at. As a result, the spread has historically been a "hidden" cost, concealed by the firm that executes your trade. Conveniently, this allows the executing firm to widen the spread when necessary, thus effectively increasing the cost of the trade without really notifying the majority of market participants.

With the proliferation of democratizing technology such as the Internet, though, the market has become more transparent: finally, the individual trader can see the spread, and thus will know exactly what the cost of the trade is prior to entering a position.

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