All you want to know but never asked about the stocks and options markets.

jueves, 21 de abril de 2016

Spreads in stock trading

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If you look at the price quoted for any given stock, you can see that there are actually two prices. The first is the buying price (bid) -how much traders are offering to buy such stock - and the second is the selling price (ask), which is the amount that traders are offering to sell that stock. In most cases, particularly in high-volume stocks in the United States, the difference between these prices - the price differential - or the difference between supply and demand (called spread) is usually only a cent.

However, in some cases, the differential or spread may become wider, and this is something that traders have to pay attention. Especially when they are trading in the short term.

What affects the price spread?

One factor that may affect the spread is the share price. For example, the expansion of a stock of $50 is often greater than the expansion in a stock of $5. While this may seem intuitive - in other words, the price spread remains as a fixed percentage of the stock price in general - the reasons for this are actually a little more complicated. The share price - and the percentage spread - play a role, but volumes are also an important factor. In other words, because the share price is higher, fewer shares change hands, leading to a scarcer portfolio of orders and more space between the prices of supply and demand.

Overall, the volume affects all actions in this way - not only high value shares. Stocks with low volumes tend to develop more abrupt breakouts in the order book known as "gaps" (a space between a closing price and opening price in a stock, without any trading activity between them), leaving certain price levels without buyers or sellers. This obviously increases the differential.

The volatility is something that can also affect the spreads in all stocks. In other words, if a stock rises or falls rapidly, then the gap between what traders are willing to pay now and the last transaction price grows as well. All buying and selling interest becomes more freely scattered because of this, leading to wider spreads.

Why spreads are so important?

For many intraday high frequency traders, their whole strategy is based on taking advantage of the price spread. On the one hand, a larger spread can result in more benefits for each trade, but also increases the risk. This is because it becomes more difficult for traders to close their positions  with benefits- in fact, the large spreads in periods of high volatility can lead to a phenomenon known as slippage, where day traders do not receive the price they want.

This is a global problem, but it can be a particular problem when they place orders stops to limit the risks - traders may end up losing more than they had expected when they opened their trades.

However, all traders - not just intraday traders - should pay attention to the spread. First, a high spread is a cost on each trade, as traders need to push back the spread before they are in profit. In addition, a high spread may indicate liquidity problems with the stock - so it is very difficult to close a trade at a certain price.

While this may not be much problem for long term value investors, it is certainly a problem for medium/short term investors who are looking to trade on trends and reversals. For example, some small penny stocks have spreads that are as high as 20%. Which means that you have to make a return of 20% just to cover expenses.

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