Numerous traders and investors new to CFDs often hear the word spread talked about by their CFD provider and ask me what it means. In brief the spread is the difference between the bid and ask price of the CFD. Spreads exist across nearly all exchange traded and over the counter (OTC) products however it isn’t a term often utilized by share traders but more frequently mentioned when discussing index and forex CFDs.
The spread of equity CFDs are often the same as the spread of the underlying security over which the CFD is derived however when trading shares this is often referred to as the bid and ask price. A number of CFD providers may widen the spread of share CFDs when there is a lack of liquidity in the underlying instrument on which the CFD is derived, others may factor their commission rate into the spread. When choosing a CFD broker it’s always imperative that you make sure the spreads of the share CFDs offered are the same as the spread in the underlying equity. Often CFD providers that widen the spread of CFDs over liquid shares as well as charging a commission are earning added revenue by making the most of their client’s lack of awareness of the price of the underlying instrument over which the CFD is based.
Spreads are regularly applied to Index CFDs. The spreads applied to index CFDs work very in a different way to the spreads applied to share CFDs for the reason that a number of CFD brokers will offer CFDs over index futures contracts even when the exchange on which they are traded is closed. Often the price of an index CFD is based on the fair value of the futures contract or cash price, CFD providers will take the price of the index and add a spread which is frequently wider than the spread on the underlying index futures contract. When the exchange on which the futures contract is quoted is closed CFD providers will often widen the spread as they are unable to hedge their customer orders. The spreads applied to index CFDs will vary according to the exchange and liquidity of the underlying futures contract.
The spreads applied to forex CFDs work in a similar manner to the spreads applied to index CFDs however as the forex market is the biggest market in the world, there’s a vast quantity of liquidity and spreads are often very tight. It is important to be aware that some CFD providers will take advantage of forex traders by quoting tight spreads for small trade volumes or during quiet market periods, but widen the spread during busy periods or when the trader becomes more active. It is not uncommon for CFD providers to differentiate themselves from by quoting variable or fixed spreads, however both have their advantages and disadvantages.
When buying and selling forex CFDs with fixed spreads traders do not have to worry about being re-quoted or spreads widening over periods of high volume, they are also able to work out their profit or loss accurately without being at the mercy of the CFD provider. Trading forex CFDs on fixed spreads can be advantageous over variable spreads especially during times of volatility where providers offering variable spreads will show exceedingly wide spreads, however trading during times of low volume will cost more. Fixed spreads tend to be suited to forex scalpers or day traders who trade frequently during volatility.
Trading forex on variable spreads also offers advantages in that customers are often able to enter the market during quite times at better prices, however all traders should beware that variable spreads are not always advantageous in that should the trader wish to exit the trade the CFD provider may show a wider spread than the spread shown when the position was opened. Variable spreads are often better suited to longer term strategy traders who do not trade during volatile periods.
In conclusion it’s vital that as a newbie trader you understand how CFD companies can use the spread to their benefit. As always it is important to make sure that you opt for a CFD provider that is able to offer you CFDs that will fit your trading system as the incorrect choice might be an expensive learning experience.
Before you start trading CFDs you should understand how CFD spreads can impact your CFD trading profits, it is crucial that you take this into account prior to selecting a CFD provider.
