What is a spread in trading: how does it affect profits

The spread in trading is the difference between the best buy price and the best sell price of an instrument. Simply put, if you can buy a stock right now at $20.05 and sell it only at $20.00, the spread is $0.05. These five cents are not visible as a separate commission, but they immediately affect the result: the trader enters worse, exits worse, or gets less space before the stop and goal.

The problem with the spread is that it only seems like a small thing on the chart. In a real deal, it turns into the cost of execution. This is especially noticeable in scalping, premarket trading, low-liquid stocks, crypto and forex during the news. The price may go in the right direction, but part of the movement will already be spent simply covering the difference between bid and ask.

What is a spread in trading in simple terms?

There are always two sides of the price in the market: bid — the price at which buyers are willing to buy the instrument, and ask — the price at which sellers are willing to sell it. The spread is the distance between them.

If the bid for the stock is $50.00 and the ask is $50.03, the spread is $0.03. If a trader buys with a market order, he usually takes the liquidity on the ask. If you immediately close the position with a market order, the sale will take place according to the bid. In this scenario, the position has not gone anywhere yet, but the trader is already in the red by the size of the spread.

In liquid instruments, the spread can be minimal: one cent in large US stocks, fractions of a point in popular currency pairs, and a small difference in large cryptocurrencies on normal exchanges. In weak liquidity, spread can become the main risk of the transaction. Not a stop, not a pattern, and not a direction, but execution.

The spread is almost always related to liquidity: the fewer orders in the glass and the sharper the movement, the more expensive entry and exit becomes. If you need to analyze separately why transactions perform worse and how liquidity affects the price, it is useful to study the material about liquidity in trading, but here we will leave the focus on how the spread itself affects profits.

How the spread eats up profits already at the moment of entry

The spread does not hit the trade when the trader has made a mistake with the direction. It appears in the calculation immediately after logging in.

Let's say the stock is trading with bid $20.00 and ask $20.05. The trader buys 1,000 shares with a market order at $20.05. On the screen, it may seem that the price is about $20, but the actual entry is already five cents higher than the best selling price. If you close the position immediately, the sale will be about $20.00, and the minus will be about $50 excluding commission and slippage.

Now let's add a trading plan. The trader wants to take a move from $20.05 to $20.45, that is, $0.40 per share. The stop is at $19.85, the risk is $0.20 per share. At first glance, the deal gives 2R: the risk is $0.20, the target is $0.40. But if the spread is $0.05, then a quarter of the risk is already embedded in the execution. The price must go through a significant part of the way just to make the position comfortable.

The smaller the target, the more dangerous the spread. For a trade with a target of $2, the spread of $0.05 is almost invisible. For a scalp with a target of $0.10, the same spread takes away half of the potential movement. Therefore, the same tool may be normal for swing trading and bad for fast intraday entry.

In forex, this logic works through points. If a trader takes a trade with a target of 8 points, and the spread is 2 points, a quarter of the potential profit has already gone to the cost of entry. Another layer is added to the crypt: the visible spread may be small, but if there is little volume in the glass, a large market order will pass through several levels and the actual price will be worse than expected.

Why is the spread widening

The spread is not a constant value. It can be narrow in a quiet session and expand sharply at a time when the trader especially wants to enter.

Most often, the spread expands due to weak liquidity. If there are few bids in the glass, buyers and sellers do not stand close to each other. A distance appears between the bid and the ask, and the trader pays more for immediate execution. This is often seen in low-volume stocks, new IPOs, thin small caps, some ETFs, and cryptocurrencies outside of major pairs.

The second reason is the news. Before a report, a Fed decision, an FDA event, a CPI, an important company statement, or a sharp gap, market participants remove applications. Market makers and active traders don't want to stand too close to the price because the risk of an instant move is dramatically higher. As a result, the spread expands precisely when volatility seems attractive.

The third reason is the trading time. In the premarket and postmarket, liquidity in US stocks is usually worse than in the main session. Even a large stock can have a normal spread during the day and an unpleasant spread before opening or after closing. This does not mean that you cannot trade outside the main session. This means that the risk cannot be assessed only according to the schedule.

The fourth reason is the size of the position. For a small volume, the visible spread may be acceptable. But if a trader is trying to enter with a large size, the best price in the glass may not be enough. Then part of the position will be worse. Formally, this is closer to slippage, but for a trader, the result is the same: the average entry price is worse than the plan.

How to account for the spread before a trade

Before entering, you need to look not only at the candle, but also at the formation. We need to understand how much it costs to participate in this transaction right now.

The first step is to compare the spread with the planned risk. If the risk of a trade is $0.20 per share, and the spread is $0.01–0.02, this is usually tolerable for a liquid instrument. If the spread is $0.05–0.08, it already takes away a significant part of the risk. If the spread is equal to half a stop, the setup becomes weak even with a beautiful chart.

The second step is to compare the spread with the target. For a trade with a target of $1, the spread of $0.03 is not critical. For a trade with a target of $0.08, it can make the idea meaningless. Therefore, scalping requires a more rigorous selection of tools: there is not much stock to cover poor performance.

The third step is to check the glass. It is important not only the distance between bid and ask, but also the volume at the nearest levels. If there are 200 shares on the ask and the trader wants to buy 2,000, the actual entry will almost certainly be worse than the best visible price. In this case, it is better to reduce the size, use a limit order, or cancel the transaction.

The fourth step is to consider the type of order. A market order gives you speed, but the trader pays for it by executing it at an affordable price. A limit order provides price control, but does not guarantee entry. A beginner's mistake is to think that a limit order is always better. If the price moves away quickly without execution, the trader may start to catch up with the market and end up with an even worse deal.

The practical rule is simple: before entering, the spread should be small compared to the stop and target, and the volume in the glass should correspond to the size of the position. If a perfect execution is needed for a transaction, but the tool does not provide it, it is better not to consider such a setup as full-fledged.

Trader's mistakes when working with the spread

The first mistake is to count the profit from the price on the chart, and not from the actual strike price. The chart may show the last trade at $30.00, but you can only buy at $30.08 right now. If the target is $30.30, the trader sees a potential $0.30, and in fact, after entering, he has less space.

The second mistake is to set a stop too short without taking into account the spread. For example, a trader buys a stock with ask $15.10, bid $15.02 and puts a stop at $15.00. Visually, it seems that the risk is about $0.10. But if the exit by stop occurs through a bid, the real risk may be greater. In fast movements, slippage will also be added.

The third mistake is to trade an illiquid instrument of the same size as a liquid one. In Apple, Nvidia, or a large ETF, a trader can get used to tight spreads and fast execution. Then he transfers the same approach to a thin stock, where the spread is wider, there is less volume, and it takes longer to exit the position. The strategy may be the same, but the economics of the deal are already different.

The fourth mistake is to ignore the spread expansion before the news. Before a report or an important macro release, the market may look active, but the orders in the glass are becoming less reliable. A trader enters the market, gets a price worse than expected, and then sees a sharp movement against himself. Even if the idea was logical, execution makes the risk uncontrollable.

The fifth mistake is to average a bad input in order to "fix" the spread. If the first purchase was worse due to the wide difference between bid and ask, adding a position does not solve the problem. It increases the dependence on a tool that already has performance problems.

When is it better to skip a trade because of the spread

It is better to skip a trade if the spread is too large relative to the stop. If the stop is short and the spread takes up a third or half of the risk, the trader enters the position with poor math. The price has not done anything wrong yet, and the transaction already requires too precise movement.

The second signal is that the spread has expanded dramatically for no clear reason. If a few minutes ago the difference was $0.02, and now it has become $0.15, you need to understand what has changed. Perhaps the news came out, liquidity disappeared, aggressive momentum began, or the instrument entered a chaotic phase. It is dangerous to enter at such a moment just because the candle looks strong.

The third signal is that there is no volume in the glass to match your position size. A small spread by itself does not save if there are tiny orders at the nearest levels. For a trader, not only the best price is important, but also the opportunity to enter and exit without a strong deterioration in the average price.

The fourth signal is that the target is too small. If the deal is designed for a short movement, but the spread is already taking a significant part of the potential, it is better to look for another instrument. This is especially true for fast transactions in crypto, thin stocks and premarket.

The fifth signal is that the price is moving in spurts, and bid and ask are constantly jumping. In such a situation, it is difficult to assess the risk in advance. The stop may be executed worse, the profit margin may be less, and the limit order may remain unenforceable. If a strategy requires a careful entry price, such a market is not suitable for it.

Short withdrawal

The spread in trading is not a small technical detail, but a part of the real value of the transaction. It affects entry, exit, stop, target, and position size. The shorter the deal and the worse the liquidity, the more the spread eats up profits.

Before entering, you need to check three things: how large the spread is relative to the stop, whether there is enough volume in the glass to fit your size, and whether the trade still has a normal risk-to-profit ratio after actual execution. If the setup stops working without an ideal price, it is better to skip such a deal.