What is a Spread? – Spreads Explained for CFD Trading

Updated on: 6 January 2020

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The road to financial trading is filled with obstacles and if you are to become at least half as good as you hope to be, you have a lot of information to deal with. Notions like margin, leverage, breakeven price, spread and everything in between serve as the foundation for understanding how the trading sector functions.

So, today we are going to talk about the spread and what exactly makes it such an important concept for any trader, regardless of his experience. In the financial industry, the spread represents the difference of value between the buy price and the sell price and it is applicable to any type of asset or goods being transacted.

An incursion into the basics of financial trading

Let’s take an example of that, so it will be easier to understand:

In financial terms, the spread is the difference between the bid and the ask price. In this case, we have an asset positioned under the 2 main tags – SELL and BUY. The BUY is the bid price and the SELL is the ask price. These are the 2 options you, as a trader, can operate under.

What you will notice is that the asset’s SELL tag displays 5,589.4, whereas the BUY tag displays 5,590.4. Here, as you can probably see, the spread equals to 1.0, because that is the difference between the SELL and BUY. This value will constantly vary depending on a number of factors, but the principle remains the same, which is: there will always be a difference between the ask and the bid price you can exploit.

Now, there are several aspects you need to take into account when talking about the spread:

– The buy price will always be higher than the sell price – If it would have been the other way around, nobody would have bought anything, ever, because the profit would have been all gone. You can see that when you are trading currency. The BUY and SELL options will always differ by the fact that the BUY option will always hold the higher value.

It is how both brokers and traders make profit, as long as they get to take advantage of the spread (the difference between BUY and SELL) and create profit.

– A tight spread makes room for larger profits – It is one of the basics of spread. Think about it logically. If you are able to buy for almost the same price you could sell it for, making profit would be extremely easy, because you will have more room to add financial value to the asset before selling it.

On the other side, if the spread gap is too large, you probably won’t have any profit margin at all. You can’t buy extremely high and sell it for an extensively higher value.

– The value of the spread is dictated by the number of market participants – This is a good thing, because it gives you the opportunity to develop specific strategies to increase your chances of making profit. What is more important to keep in mind is that the more participants take part in transacting a certain asset, the tighter the spread of that particular asset becomes.

The reverse is that the spread loosens up when the number of traders decreases.

– The value of the spread is also dictated by major market events – They don’t even have to be major, because anything that happens on the market, no matter how small and petty might seem, will send ripples through it. The only thing that differs is the intensity.

This means that having a solid grasp of what is going on in the economic and financial spheres is one of the must-dos if you are to either avoid unpleasant surprises or take advantage of the pleasant ones.

Is it necessary to know all these facts? Absolutely. I would even go one step further and claim it is imperative. I have seen a lot of people, at one point successful traders, who have almost been ruined by not paying attention to the spread and investing more than they should have.

Which goes to show keeping your eye on the spread is important from two perspectives: it helps defining your profits and it can help you save your money or cut the losses, when things go south.

The benefits of spread betting

There is an important thing we need to mention before jumping to the actual benefits. Spread betting is illegal in the US. Not illegal in the UK, though, so, if you are interested in this form of trading, you know what you have to do. By any means, refrain from resorting to any practices that are against the law. It will never end well for you.

With that being said, here are some actual advantages of taking on spread betting:

1. You are trading on a margin

You know how the margin functions, right? You only need to bid a certain percentage of the asset’s value, instead of buying the asset entirely. This translates by lower investments and higher payouts.

2. The market is open 24 hours per day

This means you are not limited by specific timeframes, which is something you won’t find on the traditional markets.

3. The profits are tax-free

Unlike buying and selling shares, for instance, this time you are not requested to pay any type of capital gains taxes on your raw profits. At the same time, you are not required to pay any commissions either, since they are already included by the spread bid.

4. Multiplying your gains with the help of leverage

The leverage lets you bid based on a percentage of the asset’s value (which represents the margin). In other words, you can open and maintain a position with only a fraction of what that position would require your deposit to be. Needless to say, your gains will increase exponentially when the market moves in your favor, while your financial efforts are minimum.

5. Using short positions

It doesn’t matter where the market heads. One of the main spread betting benefits is that you make money from both rising and falling markets. It is all up to how you decide to play your cards.

In theory, everything seems easy enough. If everything goes well, you should be able to hit it big with no problem. But we both know that is now how things function. As a result, you have a lot of things you need to be cautious about. Some which you can control, some which you can’t.

The risks of spread betting

Like I said, there are some risks, the majority of them, that you can actually prevent for the most part. Other, unfortunately, will be completely out of your control, an aspect that lays at the very foundation of the trading business as a whole. Because, as you may know, the first lesson of trading is you can’t control the outcome 100%.
So, we are going to take these risks one by one and see what you should expect when going into the business.

1. Avoid shady brokers

One of the main problems most people find themselves buried in is that they get ripped by their own brokers. Some resort to spread manipulation without their consent, leading to the brokers increasing their profits, while their clients take the losses.

Your best course of action would be to only select those brokers with a pristine reputation and recommendations. Trust me, there are more dirty brokers out there than there are honest ones. As a result, you need to know what to look for.

2. The leverage

Yes, the leverage can get you a lot of money. The problem is it can take it away with the same ease. Not to mention that, in reality, the leverage can make you lose money you don’t have, as your account will fall to negative literally overnight. This is why you see people ending up owing ten times more than they have invested in a matter of days and it is all because of how the leverage works.

3. Look for the cheapest provider

I believe this one is a common sense advice. Pretty sure you didn’t actually need it. What you do need to know, though, is that not all brokers include their brokerage fees in the value of the spread bet. As a result, you may experience additional costs during the trading.

4. The market is volatile

But, then again, the market functions the same regardless of the type of trading you are focusing on. So, in this regard, it is your primary job to elaborate risk management strategies, mainly involving keeping the market under strict surveillance. This is among the best ways of preventing unwanted surprises.

Is spread betting worth it?

At the end of the day, I guess this is where we draw the line. After all, what truly matters is being aware of the risks and knowing what strategies to adopt to minimize them as much as possible. You may have noticed I said nothing about knowing the benefits. That is because, once you can protect yourself from the risks, the benefits will come on their own. You don’t need to summon them.

So, is spread betting worth risking your money? Let me start with the conclusion: yes. And here is why:

– You can choose when to make more money – If you have read this article carefully, you know by now that the most advantageous situation for you is when the spread is tight, right? What does that tell you? It is pretty simple: only start trading when the market is at its peak. The more traders buy and sell and create a competitive environment, the tighter one asset’s spread will become. Which equals larger profits.

– Only trade main currencies – This is closely related to the first point. The main currencies are those that attract all the focus. This will narrow the spread value as a result. If you want to go for secondary currencies (in the sense of their importance on the market), they will automatically offer a wider spread and, thus, less profit.

– Learn when or when not to risk – I agree, this one tip focuses on experienced traders, those who already know what they are doing. But it doesn’t hurt to keep it in mind as a beginner as well. If you are like me and work hard, learn and adapt fast, you will probably develop a certain risk sense, knowing when a trade is worth it and when it isn’t.

My last advice would be this. Learn all about financial spreads. Learn and improve your game and, most importantly, never lose sight of your goals and don’t lose focus. In this industry, what comes around goes around.

And your main focus should be on making it come around more often.

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