What is the Bid-Offer Spread?

The financial markets are basically one big auction where we have traders that want to buy an asset (and are bidding for it a defined price), and traders that are offering to sell that same asset (and are willing to sell it at a defined price). This is where the bid-offer spread derives from.

If we take a simple look at a level 2 window of Cisco Systems (CSCO) on any trading platform, we can see that on the left side we have all the market makers bidding for shares at 18.60 for their clients and on the right side we have all the market makers offering shares at 18.610. These two prices are known as the bid and offer price, available at that time in the market for CSCO.

The difference between these two prices is known as the spread – this is the commission brokers take for the buying and selling of shares on their platform.

bid offer price

We already know the price the instrument is being offered at and the price the instrument is being bid at, but we need to introduce the third party to the equation, which is you, who is trying to make a bet on the future price of Cisco System (CSCO).

Let´s take the example of the price levels above and see where you can go long and where you can go short on CSCO by betting on the spread.

We buy at the offer and sell at the bid

We first talked about the markets being an enormous auction for shares, indices, currencies, metals, you name it; and that the price of each asset is set by the offer and demand existing in the market itself. This offer and demand is what we call the bid and the offer spread.

Here´s where one of the most common mistakes in spread betting occurs; beginner traders that understand the mechanics of this auction believe that they are going to get the bid price to open a long spread bet because it´s the lowest price available and also because it´s the price ¨you bid at ¨.

On the other hand, they might think that the offer price is the price available to open a short spread bet because it´s the highest price available and because it´s the price “you offer at”. This is completely wrong.

Remember that in this big auction you are the third party speculating through spread bets and when you want to go long you have to buy from someone that´s offering; this is why you buy at the offer (the higher of the two prices).

Contrarily, when you want to go short you have to sell to someone that´s bidding and this is why you have to open a spread bet at the bid price (the lower of the two prices) not at the offer, it´s that simple.

The width of the spread matters

Understanding the spread is just the first step in this lesson, now we are going to apply what we learned to maximize our profits in a trade by choosing the tightest spread possible.

Let´s say you want to place a long spread bet of £10 per point the FTSE100, which is now trading at 6,681.00 and your spread betting firm has a spread of 6,680.00 – 6,683.00. As we already know, our entry price will not be 6,681 but 6,683 because of the spread.

Price moves in our favor and tests an area of resistance at 6,702.00 and we then decide to close it at that level. This gives us a profit of 19 points that netted £190.

Now let´s assume that we also opened the same trade with another spread betting firm and that the only difference between them is that the second firm has a wider spread of 6,679.00 – 6,684.00. In this case our entry price would be 6,684.00 making our trade only an 18-point winner and profiting £180 from it.

As this example clearly shows, we ended up paying more in commission by trading with a wider spread which affected our overall profits in the trade by 5.3%. This might not sound much but if we trade day in and day out with a normal account size, these extra commission can become quite expensive on our PnL.

Adam

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Adam is an experienced financial trader who writes about Forex trading, binary options, technical analysis and more.

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