Spreads - how do they work

[Revorocks]

Always been unsure of this. How does spread work?
Below are just hypothetical numbers to make things easier.

If DAX is priced at 11000.
You can buy for 11005
You can sell for 10995

Does this mean the spread is 10 pips?

And with regard to setting a stop loss, do I need to factor this in?

Say I'm £1pp, stop loss of 20 points. I enter the trade long at 11000, so I'm instantly 5 points down due to spread yes?
If it goes down to 10980, will it hit my stop, or does it need to go to 10975 to account for the spread? Say I wanted to limit my losses to £20 for 20 points, do I have to factor in the spread or does it work out?

Never really been a problem as I usually trade tight spreads or 1-2 pips, but I've always wondered...

Thanks

 

[tomorton]

Yes, if buy is 11005 and sell is 10995, spread is 10. Also called the bid-offer spread or bid-ask spread.

The mid-price is often what is quoted so at this point, if the mid-price is 11000, you will have to take the position at a price of 11005. If price does not move, you can only exit at 10995, so you will be down by 10 if you go long and instantly close. Think of it like buying a car from a dealer: you have to pay the dealer 11005 to get it but if you decide to sell it back to the dealer, he is not going to give you what you paid, even if you only drove round the block and back.

The stop is calculated from your entry price, so a 20 stop from 11005 would be 10985. If price quoted (mid-price) drops to 10980, your stop was already hit when the mid-price quoted went to 10990, and you're down 20.

If price goes up and you're long from entry 11005, based on a mid-price of 11000, with a spread of 10, the mid-price would have to reach 11010 before you would break even, giving you a sell price of 11005for no loss.

Beware -
1. spreads can expand and contract while the mid-price stays the same
2. charts are usually built around mid-price but sometimes it is the bid price that is used.

 

[NVP]

jees could we all be cynical on this thread re brokers and spreads - Tom has kept it clean !!

 

[Rhody Trader]

The mid-price is often what is quoted so at this point, if the mid-price is 11000, you will have to take the position at a price of 11005.

The one little correction I would make is that you should be aware of the dynamics of the price feed you're looking at. The primary price feed for an exchange-traded instrument is often the most recently traded price, as opposed to the mid-rate which comes from the indicative prices (bid and ask).

 

[tomorton]

Cheers John, I had not realised this.

 

[Revorocks]

Trying to post a reply but it doesn't seem to be working. Is it just me?

 

[Revorocks]

In reply to tomorton

Thanks for the explanation mate.

So say Dax is:

SELL 10995
BUY 11005

Like you said if I buy then sell instantly, I lose 10 pips because I can only sell it at 10 pips below the price I had to buy.

With a stop loss, I'm setting a SELL price of say, 10995, so once they can fill my sell order of 10995 it will close. The price I set in my stop loss is the price it will go at. It doesn't equate to the price on my chart right?

Doesn't this mean that if it hits my stop loss. With a 5 pip spread, it would only need to go to 11000, to his my stop of 10995 (taking into account the spread?)

 

[tomorton]

Yes, that's correct. If the chart display is using mid-price, then its up to you to bear in mind the sell price will be below what you are seeing. Been caught out by that myself once, I don't mind saying.

For interest, it works this way at the other end of the trade too. If you set a limit order based on a chart level of say 11500 that you think your long should reach, and set a limit order to close the position at that number, it won't close until the mid-price is 11505.

Makes a difference with regards overheads but also screws up your TA if you forget.

 

[Revorocks]

Got it now, thanks for explaining that