Lots of traders and investors new to CFDs repeatedly hear the word spread mentioned 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 practically all exchange traded and over the counter (OTC) products however it is not a term often utilized by share traders but more commonly 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 based however when share trading this is known as the bid and ask price. Some 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 cost into the spread. When choosing a CFD provider it is vital that you make sure the spreads of the share CFDs offered mirror the spread in the underlying equity. Often CFD providers that widen the spread of CFDs over liquid shares as well as charging a fee are earning extra revenue by taking advantage of their client’s lack of understanding of the price of the underlying instrument on which the CFD is quoted.
Spreads are also regularly applied to Index CFDs. The spreads applied to index CFDs work very in a different way to the spreads applied to equity CFDs for the reason that many CFD brokers will offer CFDs over index futures contracts even when the exchange on which they’re 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 often wider than the spread in the underlying index futures contract. When the exchange on which the futures contract is quoted is closed CFD brokers will often widen the spread as they’re 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 largest 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 common 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 don’t 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 beneficial over variable spreads especially during periods of volatility where providers offering variable spreads will show exceptionally wide spreads, however trading in periods of low volume will cost more. Fixed spreads are often suited to forex scalpers or day traders who trade frequently during volatility.
Dealing in forex on variable spreads also provides benefits for the reason that traders are often able to enter the market during quite times at better prices, however all traders should beware that variable spreads are not always beneficial in that should the trader wish to exit the trade the CFD broker may show a wider spread than the spread shown when the trade was opened. Variable spreads are suited to longer term strategy traders who don’t trade during volatile periods.
In conclusion it’s important that as a newbie trader you understand how CFD providers can use the spread to their benefit. As always it is imperative to ensure that you pick a CFD provider that is able to give you CFDs which will suit your trading system as the incorrect choice might be an expensive learning experience.
Before you start trading Contracts for Difference you should understand how CFD spreads can impact your CFD trading profits, it is crucial that you consider this prior to choosing a CFD broker.