There are certain terms and special lingo that everyone needs to know in order to not just survive but also thrive in the financial markets. This would naturally include the stock market, the foreign exchange market or forex, among all the others.
In this specific instance, we are talking about the significance of the term spread and its various forms, such as interest rate spread or bid ask spread.
We are going to go over the basics of spread, what it means, what are the different types of spread, and how you can use spread in trading.
Term Spread: Defined in Simple Terms
The term spread is as basic as the term market itself. The lines between its various meanings are so hazy and close to one another that traders usually get them wrong. So this is why you are going to get the most straightforward definition of spread.
Simply put, spread is the difference between two prices. This can be quite wide ranging. For instance, the difference between bid price and ask price in the market. Or the difference that exists between the interest rates of two foreign currencies.
This difference between prices or rates are crucially important to traders in various financial markets and are also the basis for some of the most commonplace trading practices that exist in all markets.
Is Spread the Difference in Prices?
The answer to this question is both yes and no.
Yes, because at its most basic form it does refer to the difference in the price of two assets.
No, because it goes much further than that. For instance, we already mentioned that spread can also refer to interest rate spread, which was already defined above.
But even more so, spread can also refer to the difference that exists in two positions. For instance, the difference in the price of a short position and a long position. Obviously, long position is when you are buying and short position is when you are selling.
Last but not least, spread can be defined in terms of percentages for loans and mortgages. For example, imagine the prime interest for a loan is set at 4%, but the final mortgage or loan that is given out to the end user is set at 6%. Naturally, there is a 2% spread in the interest rates for loans in this situation.
The Use of term Spread Trading Strategies
As was mentioned in the introduction, the term spread is among the most fundamental notions related to various strategies of trading.
In fact, in many different markets, various forms and types of spread are used to make profits. As we normally focus more on the forex market, it is noteworthy to mention that interest rate spread and especially the bid-ask spread are quite significant for traders in this market to make profits.
This is why in the next sections, we are going to discuss different types of spread, including the bid-ask spread, interest rate spread, and also spread trade.
What Is the Bid Ask Spread?
You know the basics. Bid-ask spread refers simply to the difference between the bid price and the ask or offer price.
It can even be more straightforward than that. Bid-ask spread is the difference between what the buyer is offering and the price that the seller is asking for.
Again, we are going to focus primarily on the role that this type of spread plays in the forex market. But if we want to put this spread in a way that is more general we can relate it to supply and demand.
Of course, the notions of supply and demand exist in all markets. In this case, we can relate bid to demand and ask to supply.
The way this spread is extended in the forex market is through two important definitions – i.e. market maker and price taker.
In the whole forex domain, you as the trader are the price taker and the broker is the market maker.
A price taker is simply the client or the trader and they would always buy the ask price and sell the bid price. On the other hand, a market maker is a bigger participant in the whole process – i.e. the broker in this case. And the market maker buys and sells at exactly the opposite.
What Is Interest Rate Spread?
Interest rate spread can be put as the difference in the interest rate of two foreign currencies. But why is that important? And how does the difference between these two rates from two completely different currencies relate to each other?
The secret is in the name. Foreign currencies. This form of spread is predominantly used in the forex market.
The way it works is that you can profit from this difference. So traders can sell (take a short position) foreign currencies with a higher interest rate and then with that buy (take a long position) foreign currencies that have a lower interest rate. The difference between these two interest rates can help you make profits.
For instance, there is an interest rate spread between the British Pound and the United States dollar that is a little bit over 1 percent. So as long as you hold that position for the trading pair GBP/USD you will earn the spread in the interest rates as profits on a daily basis.
So you will earn a little more than 1 percent every day. For other currencies and currency pairs, this spread or difference can be much higher and therefore the profits can be more significant.
What Is a Spread Trade?
The spread trade has to do with the positions themselves. In essence the price difference between a long position and a short position makes the spread trade.
The way spread trade can work in the benefit of the trader depends upon one simple principle. First, there is the notion that if the trading is assuming a long position, it is in the hope that the prices would appreciate and thus you would profit from your initial position.
On the other hand, the main aim of a short position is that prices would decline and then profits will be made through that.
The term spread on its own plays a crucially important role in all financial markets, including the foreign exchange market. In its essence, spread refers to a difference. This difference is usually a difference in prices.
This would for example form the bid-ask difference, which is the difference in the price of buying and selling basically. But it can also refer to the difference in the percentage of interest rate for different foreign currencies and also the difference between the rate of mortgages and loans in their prime interest and final interest.