Why do spreads widen?

In times of extreme volatility, it’s not uncommon to see bid-offer spreads widen, with market depth and the efficiency at which orders are executed dramatically reduced. This isn’t a factor specific to Pepperstone’s clients, but across the whole financial market landscape, including all institutional and retail market participants.

Why does the bid-offer spread change?

The predominant driver of the bid-offer ‘spread’, or what’s essentially the difference between the best available price to buy or sell an instrument at market, is liquidity and the rate of change in the price. In times of extreme volatility or movement in price, liquidity is one of, if not, the single most important aspect of trading, especially for institutional participants, such as pension or hedge funds. Liquidity is often one of the first variables that’ll be impacted by a shock to the system or a major market event, and as liquidity deteriorates, price moves are exasperated.

We see that a reduction in market liquidity begets even worse market liquidity and it’s a key factor driving price moves in markets right now.

So what do we mean by ‘liquidity’?

Liquidity is the ability and the ease by which market participants can get in, or more pertinently, out of an open position. This is incredibly important for institutional funds, who deal in large size and aren’t seeing sufficient volume at the ‘top of book’ (or the best buy or sell price) to facilitate the full size of their order over a given time.

In a market considered to be ‘liquid’, a trader would have the confidence of executing these large orders without moving the price to any great degree. However, in an environment where there’s incredible anxiety and price volatility, market participants may trade far more frequently, but are forced to radically reduce the position size they’re trying to execute.

The sellers, by way of example, sensing the capacity for the price to move aggressively, will be less compelled to cross the spread and execute the trade at the best buy (bid) price, especially when they see such poor volume and market depth. So, they’ll often leave sell orders at an ever greater (i.e. higher levels) premium than what would typically be considered to be a ‘fair price’.

On the opposite side of the ledger, a buyer will have the choice of executing an order at the top offer price, or again, in a fast-moving market lacking any real depth, they could also leave their order at a discount (lower levels) to the ‘fair price’ – subsequently, as these market orders get pushed further from a ‘fair price’ (or the mid-price), we see the bid-offer spread moving wider.

In a truly efficient world, where liquidity is abundant and market depth is rich, market participants will fight to offer the most competitive prices and we see extremely tight bid-offer spreads. But if the market conditions are unfavourable, the buyers and sellers will look at ever bigger discounts/premium to the ‘fair price’. These price differentials are passed to all brokers from their liquidity providers. Hence in these incredibly volatile times, we see the cost to transact at market increase across all markets, be it FX, equity indices, shares or commodities, but to differing degrees.

For more information on our spreads and costs to trade with us, simply reach out.