In basic terms, the spread is the difference between the Bid and Ask price of a stock.
As with buying a share using a traditional stockbroker, there is a bid price and an ask price involved with spread betting.
Example: How prices are quoted
Say a stockbroker is quoting the shares of an company at Bid 99.75 – Ask 100.25.
This means that if an investor wanted to buy the stock of this company via this stockbroker, then he would have to pay 100.25 per share.
If the investor wanted to sell some of his existing stock then the stockbroker would be willing to take them off his hands at 99.75 per share.
How the Bid-Ask Spread is Determined
The bid-ask spread is the income that spread betting company makes for providing its service. The spread also compensates the company for the risk involved.
The difference between the bid and the ask price is known as the bid-ask spread and is the income that the spread betting company makes from providing its service.
It also compensates the company for the risk involved. The main risk being the chance of the share price moving in between the time that the spread betting company has taken on a position from a customer to the time when he closes out his position.
The spread betting company can close out his position in two ways:
– another investor comes along and wants to do the opposite trade for the same number of shares;
– he goes to the market to flatten out his position.
If the price of the underlying market has the potential to move wildly before the company can close out the position then Stockbroker ABC will set the bid-ask spread wider.
The bid-ask spread is determined by two predominant factors: volume and volatility.
Volume: is the number of trades in the stock in a given time period. This is determined by, amongst other things, interest in the market from traders.
Volatility: can be determined by how large the price fluctuations have been historically over a given time period and is normally expressed as a percentage move over a time period of one year. Of course, the amount it can move by on any given day may be significantly more, or less, than how it has moved historically.
The higher the volume is for a stock, then the more likely that the company will be able to flatten out its position with relative ease, so the price charged for providing its service will be less resulting in a tighter bid-ask spread.
Conversely, the higher the volatility of a stock, the less likely it is that the company will be able to flatten out its position so the bid-ask spread will be wider.
A third determinant of the size of the spread is the strength of competition from other firms. The more firms there are quoting for a particular stock or market, then the tighter the spreads will be.
We would expect stocks or markets with high volatility, that trade infrequently and that are not widely quoted will have larger bid-ask spreads. These tend to be the stock of smaller companies that are vulnerable to unexpected news events that could dramatically impact the fortunes of the company.
The same applies to the currencies or financial markets of emerging market countries.