How a spread is formed

Every tradeable market quotes two prices at once. One is the highest price at which somebody is currently willing to buy, and the other is the lowest price at which somebody is currently willing to sell. The buying price is the bid, the selling price is the ask or offer, and the distance between them is the spread. It is not added to the market by an intermediary. It is what the market looks like when the people in it are asked to commit to a number, and it exists for the same reason a second hand car has an asking price and a trade in price.

Because a position is opened at one of those prices and closed at the other, a position is behind by the width of the spread the instant it exists. That is a mechanical consequence of a two way price, not a charge, and it is the reason the spread is discussed as a cost even though no money is debited for it as a separate line.

The two sides of a book 

Behind a single quoted spread sits a list of orders on each side, sorted by price. The buy side is ranked from the most aggressive downwards and the sell side from the most aggressive upwards, each price level carrying the quantity available at it. The best bid is simply the top of one list and the best ask the top of the other, and the quoted spread is the gap between those two rows. Everything below them is still real, still tradeable and still relevant to anything larger than the quantity sitting at the top.

Two populations produce those orders. One is participants who want to transact and are willing to cross the gap to do it immediately. The other is participants willing to wait, quoting both sides and earning the difference when both sides eventually trade against them. The second population is what a market maker or a liquidity provider is, and the spread is the compensation for standing ready to take the other side of a trade whose direction is unknown.

What sets the width 

A firm quoting both sides is exposed to two costs, and the spread has to cover both. The first is inventory risk: whoever takes the other side of a trade holds the resulting position until it can be offset, and the price can move against them in the meantime. The wider the plausible move over that holding period, the wider the quote has to be for the position to be worth taking. This is why the spread on an instrument tracks its volatility more closely than anything else.

The second is adverse selection: some of the traders crossing the spread know something the quoting firm does not, and the quoting firm cannot tell which ones. Every quote is therefore priced for a population that includes better informed counterparties, and the greater the proportion of informed flow the quoting firm expects, the wider it quotes. This is the mechanism behind spreads widening in the minutes around a scheduled economic release, before the number is even published: the expected proportion of informed flow has risen, so the quote widens in anticipation.

Competition works in the opposite direction. Where many firms quote the same instrument, each has an incentive to quote a fraction tighter than the others in order to be at the top of the book and receive the flow, and the spread compresses towards the point where the compensation barely covers the two risks. Instruments quoted by many firms in large size therefore carry narrow spreads and instruments quoted by few carry wide ones, with everything in between explained by the same pressure.

• Volatility. A wider plausible move over the holding period requires a wider quote to compensate for inventory risk.
• Number of competing quoting firms. More firms at the top of the book compress the distance between them.
• Time of day. An instrument quoted mainly by firms in one region widens outside that region's working hours, when fewer of them are quoting.
• Scheduled events. Expected informed flow raises the quoted width before the event, not only after it.
• Size. The distance between the best bid and the best ask describes only the quantity available at those two prices. Larger quantities reach deeper levels, where the effective distance is wider.

The quoted spread and the effective spread 

A quoted spread describes one quantity only: the amount resting at the best bid and the best ask. An order larger than that quantity does not trade at one price. It consumes the top level, then the next, then the next, until it is filled, and the price it achieves is the quantity weighted average of every level it touched. The distance between that average and the mid price is the effective spread, and it is the number that describes what the transaction actually cost.

The gap between those last two rows is why execution is reported as an average and why a quoted spread is described as typical rather than as a guarantee. The quoted number is accurate about the top of the book and silent about everything beneath it.

Fixed and variable quoting 

Some firms quote a spread that does not change through the day and others pass through a spread that changes tick by tick. Neither is inherently cheaper, because the underlying costs being covered are identical and only their packaging differs. A fixed quote holds a width wide enough to survive the volatile part of the session, which makes it wider than the market during the calm part. A variable quote tracks the market down when conditions are quiet and up when they are not.

The honest comparison between the two is not the headline number. It is the total of spread plus commission over a representative sample of the hours a position is actually opened in, which is why cost comparisons that quote a single best case number for one instrument at one moment tell a reader very little. A firm quoting variable spreads with a separate commission and a firm quoting wider spreads with no commission can arrive at the same all in cost by two different routes.