What are spreads, and why are they important?

Spreads are a fundamental concept in trading and investing, but they often confuse beginners due to their various meanings across financial markets. In CFD (Contract for difference) trading, spreads play a central role, directly influencing your costs and profits. Understanding how spreads work and why they matter helps traders make informed decisions and minimize unnecessary costs.

In this article, we’ll explore the meaning of spreads, their role in CFD trading, and their importance in other types of trading.

Content

1. What are spreads in finance?
2. Understanding spreads in CFD trading
3. Factors that impact spreads in CFD trading
4. How spreads affect CFD trading costs
5. Why are spreads important in CFD trading?
6. Different types of spreads beyond CFD trading
7. Tips for managing spreads in trading
8. Key takeaways
9. Final thoughts

What are spreads in finance?

Definition of spread

In finance, a spread typically refers to the difference or gap between two related values, such as prices, rates, or yields. Its specific meaning can vary depending on the context:

• In stock trading, the spread is the difference between the bid (buy) and ask (sell) prices.
• In bond markets, it reflects the yield differential between two securities.
• In options, spreads represent strategies that involve buying and selling multiple contracts.

Spreads and CFD trading

In CFD trading, spreads usually refer to the bid-ask spread. This is the difference between the price you can sell a CFD (bid price) and the price you can buy it (ask price). The spread is essentially the cost you pay to open a trade.

For example, if the bid price of a CFD is 1.40655 and the ask price is 1.40670, the spread is 0.5 pips. This means you need the asset's price to move beyond the spread to make a profit.

Understanding spreads in CFD trading

Bid-ask spread in CFD trading

The bid-ask spread is one of the most important concepts for CFD traders.

• Tight spreads (e.g., 0.5 pips) indicate high market liquidity and lower transaction costs.
• Wide spreads (e.g., 5 pips) suggest lower liquidity or higher market volatility, making trades more expensive.

Example:

Imagine trading a CFD on a stock with the following prices:

• Bid price: $50
• Ask price: $50.10
• Spread: $0.10

If you buy at $50.10 and the stock’s price rises to $50.20, your profit would be $0.10 after covering the spread cost.

How are CFD spreads measured?

In CFD trading, spreads are often measured in pips, a standard unit used to express price changes in financial markets, particularly forex. A pip represents the smallest price movement in a given market, typically the fourth decimal place in most currency pairs or the second decimal place for pairs involving the Japanese yen.

For CFDs tied to forex, this measurement helps traders quantify the cost of the spread and assess how market movements will affect profitability. For example, if the bid price of EURUSD is 1.1050 and the ask price is 1.1052, the spread is 2 pips. In this scenario, the trader needs the market price to move at least 2 pips in their favor just to break even.

How pips relate to CFD spreads

• Forex CFDs: Spreads are quoted directly in pips. For example, a spread of 0.6 pips on EURUSD means the cost of the trade is 0.6 of a pip.
• Indices or stocks CFDs: While pips are less commonly used, the same concept applies, where the spread is the numerical difference between bid and ask prices.
• Impact of lot size: The cost of a spread is also influenced by the size of your trade. Larger lot sizes magnify the cost of even small spreads.

Factors that impact spreads in CFD trading

Several factors can influence spreads in CFD trading, directly impacting trading costs and profitability. One key factor is market liquidity—highly liquid markets, such as major indices or popular stocks, typically have tighter spreads due to the abundance of buyers and sellers. Conversely, low-liquidity markets, like niche commodities or small-cap stocks, often experience wider spreads, reflecting the added difficulty in executing trades. Another critical factor is market volatility, where spreads tend to widen during periods of uncertainty or rapid price movements. For example, events like the release of earnings reports or geopolitical developments can increase volatility and lead to wider spreads as brokers adjust for risk. Lastly, trading times play a role, as spreads are usually tighter during peak trading hours when activity is high. Outside these periods, during off-hours or holidays, reduced liquidity can result in wider spreads.

Key factors impacting spreads:

Market liquidity:

• High liquidity markets (e.g., major indices, popular stocks) = tighter spreads.
• Low liquidity markets (e.g., niche commodities, small-cap stocks) = wider spreads.

Market volatility:

• Spreads widen during volatile periods as brokers account for higher risk.
• Examples: Earnings reports, geopolitical events, etc.

Trading times:

• Tighter spreads during peak trading hours with high activity.
• Wider spreads during off-hours or periods of reduced liquidity.

How spreads affect CFD trading costs

Spreads are a fundamental cost for CFD traders, as they determine how much you need the market to move in your favor before you can break even. Essentially, the spread acts as the difference between the price you buy at (ask) and the price you sell at (bid), and this gap must be covered before you see a profit.

Examples of spread costs in CFD trading

Imagine you’re trading a stock CFD with a bid price of $50 and an ask price of $50.10, resulting in a spread of $0.10. If you buy at $50.10, the market needs to rise by at least $0.10 (to $50.20) for you to break even. Any further movement beyond this point becomes your profit.

Now, consider a larger spread scenario:

• Bid price: $100
• Ask price: $101
• Spread: $1

In this case, the market needs to move $1 in your favor before you break even, which could represent a significant barrier, especially in volatile markets or for short-term trades like scalping.

Why traders must account for spreads in strategies

• Scalping and day trading: High-frequency traders who make many small trades are particularly sensitive to spreads, as even minor increases in spread costs can erode profits.
• Position trading: Spreads are less impactful on longer-term strategies, as the price movement is typically large enough to cover the initial cost.
• Volatility awareness: Wider spreads during volatile periods can eat into potential profits, so traders must adapt their strategies or avoid trading during these times.

By understanding and accounting for spreads, traders can plan their entry and exit points more effectively, minimize costs, and improve overall profitability.

Why are spreads important in CFD trading?

Spreads are central to understanding the cost dynamics and profitability of CFD trading. They represent the fees traders incur and provide valuable insights into market conditions, liquidity, and risk levels. By closely examining spreads, traders can better assess their trading environment and make informed decisions on when and how to enter or exit positions. Additionally, understanding spreads is crucial when comparing brokers and selecting the most cost-effective trading platform.

Cost of trading

The spread represents the primary cost of a CFD trade. Traders who frequently open and close positions, such as scalpers or day traders, must account for these costs in their strategies. Even small spreads can add up over multiple trades.

Market conditions and risk

Spreads are an excellent indicator of market conditions:

• Tight spreads: Reflect stable markets with high liquidity.
• Wide spreads: Suggest higher risk, low liquidity, or significant market volatility.

Broker comparison

Not all brokers offer the same spreads. Some provide fixed spreads, while others use variable spreads that fluctuate with market conditions. Comparing spreads can help traders reduce costs.

Different types of spreads beyond CFD trading

While spreads are critical in CFD trading, they are equally important and sometimes have a different meaning in other types of trading.

Forex spreads

In forex, spreads are the difference between a currency pair's bid and ask prices.

• Example: For EURUSD, if the bid price is 1.1050 and the ask price is 1.1052, the spread is 2 pips.
• Major currency pairs like EURUSD tend to have tighter spreads, while exotic pairs like USDZAR may have wider spreads due to lower liquidity.

Bond spreads

Bond spreads measure the yield difference between two bonds.

• Yield spreads: Compare government and corporate bonds, often indicating risk levels.
• Credit spreads: Show how much extra yield investors demand for taking on riskier corporate bonds.

Options spreads

In options trading, spreads refer to strategies involving multiple contracts. For example:

• Bull call spread: Involves buying a call option at a lower strike price and selling one at a higher strike price.
• These strategies allow traders to manage risk and limit potential losses.

Tips for managing spreads in trading

Managing spreads effectively is key to optimizing trading performance and reducing costs. First, traders should monitor market conditions closely, as events like earnings reports, economic announcements, or geopolitical developments can increase market volatility and widen spreads. Staying informed helps you anticipate these shifts and adjust your strategies accordingly. Second, choosing a broker with competitive spreads is essential. 

Some brokers consistently offer tighter spreads, especially on frequently traded assets like major forex pairs or indices. Comparing brokers can ensure you’re not paying more than necessary on trades. Finally, timing your trades wisely can make a significant difference. Trading during high-liquidity periods—such as the overlap of major market sessions—often results in tighter spreads, making entering and exiting positions more cost-effective.

At Exness, complex pricing algorithms ensure that our spreads remain stable during market news. This provides unparalleled spread tightness and predictability, regardless of market conditions or high-impact news.*

Key tips:

• Monitor market conditions: Stay informed about news events or announcements that could increase volatility.
• Choose a broker with competitive spreads: Look for brokers that offer consistently tight spreads, especially for the assets you trade most frequently. For example, Exness offers the tightest and most stable spreads on the market for BTCUSD, XAUUSD, and USOIL.*
• Time your trades wisely: Trade during high-liquidity periods to benefit from tighter spreads.

Key takeaways

1. Spreads define trading costs: Spreads in CFD trading represent the cost of opening and closing trades, directly impacting profitability.
2. Bid-ask spreads are critical: The bid-ask spread reflects market liquidity and trading costs. Tight spreads mean lower costs, while wide spreads increase expenses.
3. Market factors influence spreads: Liquidity, volatility, and trading times affect spreads. Tight spreads occur in stable, high-liquidity markets, while wide spreads emerge in volatile or off-peak conditions.
4. Spread costs affect profitability: Spreads must be covered before trades become profitable, making them critical for scalpers and high-frequency traders.
5. Spreads reveal market conditions: Tight spreads indicate stable, liquid markets, while wide spreads suggest volatility and risk.
6. Spreads vary across markets: Forex, bonds, and options rely on spreads to manage costs and risk, and each market has unique characteristics.
7. Managing spreads boosts performance: Monitoring conditions, choosing brokers with tight spreads, and trading during peak liquidity reduce costs and improve profitability.

Final thoughts

Spreads are an important concept in trading and investing. In CFD trading, the spread directly affects your costs and potential profits. Tight spreads are preferable for traders, as they reduce trading expenses and make it easier to reach profitability. Beyond CFDs, spreads play an important role in forex, bonds, and options, indicating market liquidity, risk, and conditions.

By understanding spreads and how they influence trading costs and market dynamics, you’ll be better equipped to navigate financial markets effectively.

*"Best spreads" means the tightest and most stable spreads. "Most stable" refers to the lowest maximum spreads, and "tightest" refers to the tightest average spreads – offered on Exness Pro accounts – for the above-mentioned instruments. These are compared to spreads across commission-free accounts of other top brokers over the specified period.

*Spreads may fluctuate and widen due to factors including market volatility and liquidity, news releases, economic events, when markets open or close, and the type of instruments being traded.