From a financial perspective, some weeks are more interesting than others. There are weeks where absolutely nothing happens, then there are weeks boasting a slew of economic data, such as the notorious Non-Farm Payrolls (NFP), CPI data, or perhaps the incorrigible FOMC meetings. Such busy events serve as a reminder that market conditions vary wildly throughout the year. During these times, it is important to keep our mind on market volatility, and how it may be affected by real world events. Which brings us neatly to the topic of this week’s article:

SPREADS

Any definition you hear will inform you that a spread is simply the difference between the bid price and the ask price. An adequate definition, but one that raises more questions than it answers.

The most obvious follow-up question is: why is there a difference between the bid and the ask price? It is important to remind ourselves that for every buyer, there must also be a seller. It follows that any time a trade is not currently occurring then the bid and ask price in fact do not align, because otherwise there would be a trade. Basic logic but worth reminding ourselves of it.

This raises several important points related to making a trade.

MARKET DEPTH

The fewer participants in a market, the less likely the asking price and the bid price are to align, and therefore the higher the spread. Imagine a situation where Bob is trying to sell a car. It’s a very unique car, one of a kind in fact. It just so happens that Dave, living on the other side of the world, is interested in buying it. That’s great until they realise Bob is asking for $20k but Dave is only willing to put up $10k. Quite the spread.

Now let us imagine Bob’s car isn’t so unique, in fact there are thousands of them, and most sellers aren’t as greedy as Bob. There are also thousands of people looking to buy one, and most of them are not as stingy as Dave. Suddenly we have a much healthier market. There are people willing to meet in the middle. The spread is greatly reduced.

All this to point out that spreads tend to widen when market liquidity dries up. This remains equally true in the Forex markets. All we need to do is compare the spreads on different currency pairs. The reason EURUSD typically has the smallest spread is because it is the most traded. In fact, the USD is on nearly 90% of one side of all currency trades.

The more exotic the trading pair, the lower the liquidity and the higher the spread. In Forex trading this usually isn’t a problem for the average person, but in severe cases, traders would need to adapt their strategies with the above in mind. Typical strategies include using limit orders instead of market orders, reducing and breaking down an order into multiple trades and most importantly, being patient.

In severe cases, some assets are barely tradable at all. Some small cap stocks are so illiquid that no trades happen for days at a time. Good luck getting your order filled in a hurry. In extreme cases, some of the smaller crypto exchanges have so little liquidity that one person could potentially clear the entire order book on a particularly esoteric pair.

VOLATILITY

So we have seen that poor liquidity widens spreads, but what else affects them? As it turns out, Bob’s car is now inexplicably popular. Suddenly everyone wants to buy it. Bob gets his offer for $20k but before they can even shake hands on it, the car sells to a third party for $22k. Before you know it, Bob’s car is changing hands faster than a hot potato, and bids of $30k are being thrown around. Dave’s lowly $10k bid now thoroughly left behind.

All this to point out that spreads can widen greatly during periods of rapid price change. Once again, this remains equally true in the Forex markets. We mentioned in the intro that economic data has a big impact on the market. Unexpected news or announcements can send currencies or gold flying. It is a risky environment and for this reason, many traders prefer to stay on the sidelines during such times. Ironically this makes the situation even worse, the lack of liquidity making the market even more volatile.

FOREX BROKERS

It turns out selling a car isn’t that simple, and as it happens neither is trading special snowflake trading pairs or frantically hitting the sell button during NFP announcements. We need someone to bring the buyer and the seller together, in fact we need someone to bring all buyers and sellers together, throughout the entire world, at every second of every trading hour.

Who does this? Forex Brokers. Understandably, they don’t work for free.

In the modern era of high bandwidth internet cables, super computers and server farms that take up entire buildings, spreads and fees are the price we pay for such infrastructure. To put this into perspective, spreads are an order of magnitude narrower than they were in the mid-90s.

Forex brokers are also there to soak up the shock during volatile trading times. The increased risk they take on during heavy trading sessions explains the widened spreads common during such times.

FUTURE

What does the future hold? It is true that spreads have improved greatly thanks to better technology, but the bulk of these improvements occurred in the late 90s and early 00s. In fact, there has been very little change in spreads since 2005. The problem is that there is only so much liquidity the markets can corner. So what’s the next step?

Zero spread zero commission trading is rapidly becoming more and more common, particularly in the cryptocurrency sphere. As soon as one of the bigger brokers offers such an environment as standard, the rest of the market will have no choice but to follow suit or get left behind.

Unfortunately, this raises other issues. The obvious point being: how is the broker making money if its clients can trade for free? Is the broker making up the difference by pushing its other products? Is the broker trading against its own clients?

All very opened questions so let us end with this: spreads are the price we pay to access the markets we wish to participate in, and for the foreseeable future, they will remain a staple of the financial world.