The Bid Ask Spread Part One:
Okay, let’s talk about the spread a little bit. The spread is one of the most important things when you’re trading. Basically, it’s a built in fee that you’re going to have to pay unless you can capture the spread as profit which is what market makers do. But let’s keep it simple in the beginning, so let’s talk about SPY which is the S&P 500 ETF. So I’m just going to go on some quotes that are after hours. Actually the market is closed right now. I’m going to read the quotes off the level one just we’ll make believe that they are the real quotes at this time. So for instance as SPY is quoted as 244.25 bid and 244.26 ask, so that’s a penny spread. That means for every share you trade you pay a penny in spread if you buy the ask and you sell the bid, which is most of the time what you’ll be doing. So, if it’s a penny for one share, it’s a dollar for a hundred shares and its $10 for a thousand shares.
Now your commission is going to be way less than that for a thousand shares, so the spread is actually more important than the commission a lot of the times and you’ll be paying both of them anytime you make a trade. So you have to factor in the commission that you’re paying and the spread that you’re paying when you make a trade in order to figure out what you have to make just to break even.
Now let’s go over to something that’s a lot more volatile and has a lot higher spread. I’m going to read what the quote is right now on SVXY but during trading hours it’s going to be a little tighter but it’ll still be a lot bigger than one penny. So in other words right now it’s 156.65 by 156.75 which means that 156.65 is what people are bidding that they will pay for it and 156.75 is what people are asking to sell it for. So that’s 10 cents, so on a thousand shares, that is actually $100. So that’s pretty significant.
Now your trade on a thousand shares might be like three to five bucks, the cost to trade it in commissions, but the cost of the spread is going to be way bigger than that. So what do you do about that? Well, one thing is you could try to trade stocks that have very low spreads, very tight spreads, or you could try to capture the spread by selling at the ask and buying at the bid, but that’s very hard to do. So another way to go about it is to try to get it somewhere in the middle when you trade those stocks that have the higher spreads. And if you’re lucky you might even be able to get it on your side of the middle so you make a little profit coming and going. So for instance on SVXY, you’d want to try and get it right around 156.70, if you could. You might put in a bid for that or you might even put in a bid for 156.68 or something like that. Now if it’s moving fast chances are you’re going to pay a larger portion of the spread than you think because the market makers and the HFT’s are going to execute you when it’s to their advantage. But if it’s not moving too fast you might get filled in between the spread and it might be to your advantage or you might pay very little on spread like for instance, the market makers might execute you at 156.71 which is one penny away from the midpoint. So a good rule of thumb is to try and get the midpoint on these higher spread stocks, it doesn’t mean they’re untradable, it just means they’re a little more tricky. So the spread, for those reasons, is a very important thing. It’s something you should be well aware of.
Now there are some stocks that you can execute at midpoint, and those are going to generally be more liquid stocks and there are some that you are not going to have a lot of luck executing at midpoint or even close to midpoint. So with all that said it is a good idea to be aware of what the average spread is and be aware if the spread is larger than normal for the stock that you are trading and act accordingly. If the spread gets too big and the volatility is too high on the stock you might want to avoid trading it for that particular day. If you find a stock where you can capture the spread, then that is an added edge for you. Okay that’s it for now.
