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Bid-offer spread measures the difference between the buy and sell prices.
The larger the difference between the prices the more the market will have to move to make a particular position profitable.
When the spread is zero, this is referred to as a “choice price“.
This is the simplest metric to compare between brokers (and LPs).
The bid-offer spread is typically expressed in either percentage terms or as an absolute value.
- A narrow spread indicates a highly liquid market with a large number of buyers and sellers, which often results in lower transaction costs for traders.
- A wide spread indicates lower liquidity and higher transaction costs, as traders may need to accept less favorable prices to execute their trades.
The bid/offer spread essentially represents liquidity.
Liquidity is the degree to which an asset can be quickly bought or sold on a marketplace at stable prices.
A narrower spread implies a deeper market where there is a sufficient volume of open orders so buyers and sellers can execute a trade without causing a big change in the price.
That’s in contrast to a weak or “thin” liquidity environment, where large orders tend to move the price, increasing the cost of executing trades and deterring traders, in turn, causing a further decline in liquidity.
Market makers, who facilitate trading by continuously quoting both bid and ask prices for financial instruments, play a crucial role in determining bid-offer spreads.
They earn their income through the spread, as they buy at the bid price and sell at the ask price, profiting from the difference.
Bid-offer spreads can be influenced by several factors, including:
- Market liquidity: In highly liquid markets with many buyers and sellers, the bid-offer spread tends to be narrow, as competition drives prices closer together.
- Asset volatility: For more volatile assets, market makers face higher risks and may widen the bid-offer spread to compensate for potential losses.
- Trading volume: A higher trading volume can lead to a narrower spread, as increased activity generally results in more competitive pricing.
- Market news and events: News or events that impact market sentiment can lead to temporary fluctuations in the bid-offer spread, as market participants adjust their pricing expectations.
Understanding the bid-offer spread is essential for traders, as it can impact the cost of executing trades and the overall performance of their trading strategies.
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