When trading cryptocurrency via the order book of an exchange, the highest buy order price and the lowest sell order price for a currency pair are most usually not identical. Spread is the difference between the lowest sell price and the highest buy price on the order book. This price gap is also called the bid-ask spread.
Highly liquid cryptocurrencies like Bitcoin most likely have a very small spread compared to smaller cryptocurrencies with less liquidity and trading volume.
Spread is akin to our daily life negotiations. When you want to buy a car or rent a house, there will likely be a difference between the price you are willing to pay and the price the owner is asking. But at some point, you reach a consensus with the other party at a certain price. The extra amount you end up paying over your original bid price would be the spread in your transaction.
This physical example corresponds to thousands of traders gathering in a cryptocurrency exchange. Traders submit the price that they are willing to buy or sell a cryptocurrency. In that regard, spread measures the difference between the supply (sell) and demand (buy) for a cryptocurrency. An increase in spread, therefore, represents a change either in the supply or demand.
There are two major types of spreads in an exchange — fixed and variable (floating). CEX.IO uses a variable, floating spread mechanism in its order books.
The Impact of Liquidity and Volume on Spread
Price spreads either widen or tighten, depending on the market liquidity and trade volume.
Spreads widen when the liquidity and volume decrease. They can also widen when either side of traders, the buyers or sellers dominate the market. For instance, there can be too many buy orders but too few sell orders at a given moment, which would widen the bid-ask spread.
On the other hand, spreads tighten when there is a very high interest in the market, which creates an equilibrium price between the buyers and sellers.
Bid-ask spread is critical when entering a trade. In some cases, spreads may even exceed your profit levels, which would make a trade unreasonable.
Variable Spread
As the name suggests, a variable spread is when the difference between the lowest sell and highest buy price of a cryptocurrency is subject to changes.
To implement variable spread, CEX.IO Exchange gets pricing from multiple liquidity providers, including the outstanding orders of CEX.IO users, and passes these orders directly to the order book, without any price fluctuations.
The primary advantage of using variable spreads in an exchange is the elimination of requotes, meaning order prices can never be removed and traders cannot be forced to accept prices other than their order price.
But the lack of requotes does not eliminate price slippage upon the execution of orders. This means that if the amount of your buy order is larger than the available sell amount in the cheapest sell order, then the remainder of your buy order will be filled with the next higher price sell order.
Similarly, if your sell order is larger than the available buy amount in the highest buy order, then the remainder of your sell order will be filled with the next cheaper price buy order.
Variable spreads make pricing on CEX.IO transparent because it is formed only by the competition between buyers and sellers without any intervention from the exchange.
Closing Thoughts
If you are concerned about losing capital to bid-ask spreads, you should only trade cryptocurrencies with the highest liquidity and volume. Or, you need to give a limit order for your cryptocurrency of interest and patiently wait for your order to get filled.
For information purposes only. Not investment or financial advice. Seek professional advice. Digital assets involve risk. Do your own research.
