If you are new to the trading space, then you must not be aware of the term price spread, also commonly known as Bid-Ask spread.
Although a less discussed concept, the bid-ask spread is vital in any exchange form of the marketplace and helps maintain stability. You can even see it in the stock market, how it is updated constantly during trading hours.
If you are investing with a long term view in the market, you should not be bothered about the price spreads, but if you are trading, you cannot afford to miss the concept of price spread. So, let’s have a look at it in detail.
What is a Price Spread?
Spread in financial markets refers to the difference between an asset’s buy and sell price. This concept is called the bid-ask spread because there is always a gap between the lowest ask (sell) price and the highest bid (buy) price.
- Bid-price – It represents the highest price the buyer is willing to pay for a security
- Ask-price – It represents the lowest price at which the seller is ready to sell their assets
Simply put, the buyer always wants to buy at the lowest price possible, and sellers want to sell at the highest price possible. The gap between the buyers and sellers expectations is called a spread.
It is the reason why, at any given time, the buy price (the lowest price at which someone is willing to sell) is always higher than the selling price ( the highest price someone is willing to pay).
You should note- for exchanges, the ask price becomes the buy price (as people are ready to buy at whatever prices sellers want to sell due to the popularity of the coin), which is naturally higher. Whereas, the bid price becomes sell price for exchanges as people as always willing to pay less while buying something. In the end, it’s the sellers who sell at a premium and buy back at lower prices, which is an important factor for short term traders. Not so much for investors.
How to Spread is Calculated?
At a given point in time, the spread of an asset is the difference between the highest bid price and the lowest ask price in the order book. The order book is the list of all queued buy and sell orders.
The mathematical formula is:
Price Spread= Ask (Sell) Price – Bid (Buy) Price
For example, let’s say that Bitcoin has:
A buy (bid) price of 100
A sell (ask) price of 101
Price Spread = 101 – 100 = 1 point
There are numerous buyers and sellers in the market and they may buy and sell at various price points. But, only the highest selling price and lowest buying price in the order book will be considered for calculating price spread. Below is an example of an order book and how price spread is calculated.
|Coin X Order Book|
|Ask Price||Bid Price|
|Order 1||Rs. 17||Highest Ask/Sell Price||Rs. 21|
|Order 2||Rs. 15||Rs. 18|
|Order 3||Rs. 14||Rs. 15|
|Order 4||Rs. 12||Highest Ask Price||Rs. 17|
|Order 5||Rs. 13||Lowest Bid/Buy Price||Rs. 14|
Coin X Price Spread = (Highest Selling Price – Lowest Buying Price) = (17-14) = 3
It can be helpful to know the value of spread in percentage, and it helps you determine the market’s liquidity.
The mathematical formulae to calculate the spread in percentile:
Percent Spread in % = (Price Spread – Highest Ask Price)* 100
In the above example,
Percent Spread in % = (3/17)*100 = 17.64%
How do spreads work?
You can find two prices in an exchange,
- The lowest price at which someone is willing to sell (Ask price)
- The highest price at which someone is willing to buy (Bid price)
Generally, markets with a high volume of transactions have lower spreads because they are highly liquid (more competition between buyers and sellers). For example, the stock market has a lower spread because there are more players in the market.
On the other hand, markets with less liquidity and significantly lower transaction volumes tend to have a higher spread. In cryptocurrencies, since the market is relatively new and has fewer players, there tends to be an enormous gap between the buy and sell price in some coins.
Unlike other financial markets, each crypto exchange is a mini-market by itself. Every exchange independently considers all the orders on their platform.
They maintain market order books from which they can identify the highest bid and the lowest ask price to display the buy and sell price. Based on the security’s last traded price (LTP), one can place the bid or ask rates.
Factors that affect the spread
A common misconception in the crypto market is that crypto exchanges use spreads to make profits.
On the contrary, the spread varies from one exchange to another depending on the demand and supply of the currency. Some of the other factors that determine the spread of cryptocurrencies are:
- Trading volume – The number of transactions on crypto determines its spread. For example, the trading volumes are high in the case of bitcoin in comparison to other altcoins. This means, bitcoin is being heavily traded at multiple rates at small intervals, and hence the bitcoin price is less likely to see a sharp incline and decline. This results in a relatively smaller spread than other coins with lesser trading volumes.
- Liquidity of the asset – Any asset that can be quickly converted into cash is highly liquid. If your crypto is highly liquid, the spread will be smaller. Illiquidity can cause a more wide price spread because sellers will try to get rid of their coins quickly at any given rate. If the spread is higher in any exchange for popular coins, there might be a possibility of a lot of HODLers than traders.
- Volatility – The rate at which the prices of an asset fluctuate determines its spread. If the asset is highly volatile, the spread can be significantly wide and vice versa. For example, the spread in the crypto market is much wider than in the stock market due to its highly volatile nature.
How does Price Spread Impact Crypto Trading?
Price spreads have a pivotal role in the performance of your trading strategies.
When you consider investing or trading in any cryptocurrency, you may want to take a closer look at the price spread of the currency. Since price spreads are impacted by liquidity and volatility, you can use it as an indicator while trading. An example to help you understand better.
Suppose that you want to invest in ‘X’ currency. Its highest sell price (ask/offer) is ₹100, and the lowest bid/buy offer is ₹95. The price spread of this currency is ₹5 or using our percentage equation, there is a spread of 5 %. That is a significant spread, which means that the currency ‘X’ has lower liquidity and can be highly volatile.
If you were to buy this cryptocurrency for ₹95, you would have to wait till the best ask price comes down to ₹95. Or, you need to increase the bid price substantially.
On the other hand, currency ‘Y’ has the lowest bid offer of ₹100 and the highest ask offer of ₹101. In that case, the spread of the crypto ‘Y’ is 1, which is 1% in percentile. A spread of this size is standard for a volatile asset such as cryptocurrency, and it means that the currency ‘Y’ has higher liquidity and is more stable than currency ‘X’. Since the spread is narrow, you need not wait long if you were to buy the cryptocurrency ‘Y’ at ₹100. So, booking a profit is easier with currency ‘Y’ than currency ‘X’.
In the real world, cryptocurrencies such as Bitcoin, Ethereum etc. – currencies having high trade volumes and liquidity have narrower spreads than relatively new altcoins. It is generally far easier to make money on a cryptocurrency with a tighter spread than one with a broader spread. Thus, before buying any cryptocurrency, it is wise to check the asset’s spread.
Before jumping to the conclusion that price spreads impact your portfolio negatively, take a second and think about its significance. No spread in a market means the asset is not being traded.
While it may impact your trade in the short run, price spreads do not significantly affect long-time hodlers. Also, you know very well that the longer you hold on to any asset, the stronger your portfolio will be.
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Disclaimer : Crypto products and NFTs are unregulated and can be highly risky. There may be no regulatory recourse for any loss from such transactions. The information provided in this post is not to be considered as investment/financial advice from CoinSwitch. Any action taken upon the information shall be at user's own risk.
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