Let's talk spread
Hi guys, it's the team at SpreadEx here. Ironically, we wanted our first post to be about our name... 'spread'. So what is it, and how does it work in trading? Let's dive in...
The Impact of Spread in Trading
Brokers advertise the lowest spread. Everyone cares about it. But… why?
Well, firstly let’s define the spread in and trading.
In the most simple terms, it’s just the difference between the bid and ask price.
You buy an asset at the best price the broker (hopefully) can ASK for an asset or security, and you sell at the best price a broker can BID it from you at.
Simple!
But what determines the spread?
Again, in very simple terms, it is information, and information = liquidity.
If the spread is increasing, there is less information from flow (other participants’ orders) and so less willingness for market makers to be involved in the market, which means market makers quote wider until more information returns.
This is why at news events you might see extremely wide quotes - no one wants to risk capital to the same extent when there is a rise in uncertainty from economic news.
The role of market makers
Many participants think market makers are some sort of all powerful being that controls how the market moves.
This is very much not the case - all market makers do is quote prices both ways depending on the information they can collect from what’s going on.
They then make money from the spread and aim to be flat by the end of the day (carrying overnight inventory is a risk!).
They operate in a delta-neutral manner, which simply means they don’t care about which way the market is necessarily going, they simply want people to be trading so they can make profit from the spread.
In fact, they’d probably love it if a market constantly traded in a completely flat range with a tonne of volume so they could quote without there being much directional risk!
Example of importance of information for market makers
In the US (not the UK, we are far more sensible!), there is a type of business called payment for order flow.
You’ve probably heard of this over the pandemic discussions about markets where [\]Citadel was apparently the big baddie and Robinhood traders were getting picked off by the big bad market maker.
Yes, it is true that Citadel received retail trades, but no it’s not true they were being picked off.
See, the reason Citadel wanted Robinhood’s orders is because their users are classed as ‘uninformed’ - yes, the designation is as simple as that.
If you have uninformed flow, it means you can quote a tighter spread (more information) which means you are providing best price.
Best price = more flow and more revenue.
Simple!
But what is ‘informed flow’?
Informed flow is, well, flow that is generated by those who have superior strategies, larger size, fast execution and whatever else that your typical institutional firm might have.
It’s likely that this contributed to the Covid-19 crash back in March 2020.
It was found there was a lot of informed flow in the market just before the crash, which likely meant market makers stopped providing liquidity since it is not their preference to make a market against this informed (also known as ‘toxic’) flow.
And if there is no liquidity, we get a lovely collapse!
Bottom line: The spread is very important - as a trader you should be analysing your transaction costs and seeing how you can optimise (evident fix here is to see whether your execution times are at quiet parts of the day).
The Impact of Spread in Trading
Brokers advertise the lowest spread. Everyone cares about it. But… why?
Well, firstly let’s define the spread in and trading.
In the most simple terms, it’s just the difference between the bid and ask price.
You buy an asset at the best price the broker (hopefully) can ASK for an asset or security, and you sell at the best price a broker can BID it from you at.
Simple!
But what determines the spread?
Again, in very simple terms, it is information, and information = liquidity.
If the spread is increasing, there is less information from flow (other participants’ orders) and so less willingness for market makers to be involved in the market, which means market makers quote wider until more information returns.
This is why at news events you might see extremely wide quotes - no one wants to risk capital to the same extent when there is a rise in uncertainty from economic news.
The role of market makers
Many participants think market makers are some sort of all powerful being that controls how the market moves.
This is very much not the case - all market makers do is quote prices both ways depending on the information they can collect from what’s going on.
They then make money from the spread and aim to be flat by the end of the day (carrying overnight inventory is a risk!).
They operate in a delta-neutral manner, which simply means they don’t care about which way the market is necessarily going, they simply want people to be trading so they can make profit from the spread.
In fact, they’d probably love it if a market constantly traded in a completely flat range with a tonne of volume so they could quote without there being much directional risk!
Example of importance of information for market makers
In the US (not the UK, we are far more sensible!), there is a type of business called payment for order flow.
You’ve probably heard of this over the pandemic discussions about markets where [\]Citadel was apparently the big baddie and Robinhood traders were getting picked off by the big bad market maker.
Yes, it is true that Citadel received retail trades, but no it’s not true they were being picked off.
See, the reason Citadel wanted Robinhood’s orders is because their users are classed as ‘uninformed’ - yes, the designation is as simple as that.
If you have uninformed flow, it means you can quote a tighter spread (more information) which means you are providing best price.
Best price = more flow and more revenue.
Simple!
But what is ‘informed flow’?
Informed flow is, well, flow that is generated by those who have superior strategies, larger size, fast execution and whatever else that your typical institutional firm might have.
It’s likely that this contributed to the Covid-19 crash back in March 2020.
It was found there was a lot of informed flow in the market just before the crash, which likely meant market makers stopped providing liquidity since it is not their preference to make a market against this informed (also known as ‘toxic’) flow.
And if there is no liquidity, we get a lovely collapse!
Bottom line: The spread is very important - as a trader you should be analysing your transaction costs and seeing how you can optimise (evident fix here is to see whether your execution times are at quiet parts of the day).
Disclaimer
The information and publications are not meant to be, and do not constitute, financial, investment, trading, or other types of advice or recommendations supplied or endorsed by TradingView. Read more in the Terms of Use.