Have you ever noticed why there is such a large spread between the buying and selling price of real assets and those of financial assets charged by a specialised dealer of those assets. Try taking a car to an automobile showroom and ask the value of the car.
The chances are the same the car is being sold at that showroom at 6-10% above the price being offered to you. Are you being ripped off?
LIQUIDITY, LIQUIDITY, AND LIQUIDITY: While the location of the dealer will have something to do with the spread between his buying and selling price, it is more to do with liquidity of the asset he is selling.
The layman on the street believes that the buying and selling spread is something extraneous, to which all traders adhere, it is set by some committee or a group of individuals, at their whim and fancy.
The truth cannot be further away from this. The answer is quite complex and involves a number of factors that form the basis of trading principles.
MARKET LOT SIZE: This is fundamental to the whole process of market making and trading. The lot size of a particular trade depends on the:
-- number of participants in the market;
-- quantum of capital of the market makers (it defines the maximum risk appetite of these participants);
-- level of net open position allowed by regulators or the management, whichever is lower;
-- maximum capital of any one player vis-à-vis the entire market (or the ability to have an undue influence on the market);
-- frequency and size of market takers trading with market makers;
-- market price adjustments needed to attract participants to provide liquidity;
-- frequency and volume of unanticipated supply and demand flows to the markets;
-- maximum build-up of position in any one direction before natural flow trickles back into the market; and
-- economic value of transacting a trade under normal bid/offer spread.
PARTICIPANTS: It's more than market maker or market taker, it's the difference between liquidity provider and liquidity user.
This is why between market makers the spread between the bid and offer is much narrower than those experienced by corporate entities or retail clients off-setting their market risk.
These market players, may in certain instances accept to provide liquidity (exposing themselves to market risk) and in other times are users of liquidity (eliminating market risk).
The corporate entities are generally always using the markets to eliminate risks and as such other market players may never off load their risks on these corporate entities.
Trading in a developed market - Let's take a look at the key elements a fresh trader needs to know before trading in a developed market, where the rules and risks of trading are more well defined than in other markets.
Say that the last trade in the foreign exchange market, for example, EUR/USD, has happened at 1.2000/05. At the beginning of the day, for a day-trader who has started his net open position at zero.
THERE ARE THREE POSSIBLE VIEWS TO START WITH (ASSUMING NO INFORMATIONAL UNCERTAINTY EXISTS IN THE MARKET)
1. BULLISH: His bias is to buy EUR against USD, his bid would be better than the inter-bank market while his offer would be worse than the market, or his bid would be at or slightly below the last traded value. eg 1.2001/06
2. BEARISH: His bias is to sell EUR against USD, his offer would be better than the inter-bank market while his offer would be worse than the market, or his offer would be at or slightly above the last traded value eg 1.1999/04
3. NEUTRAL: He is willing to buy EUR against USD at the inter bank bid rate and sell it at the inter bank offer rate or in the absence of such a rate being available use the last traded price as the mid price and determine the bid and offer (equidistant from mid price) using the normalised spread eg 1.2000/05
The bullish or bearish view may either have technical or fundamental as the underlying reason. To explain the technical, it is important to understand that historic price movement is used to predict future price movements ("trend is a friend").
While fundamentals refer to explicit economic statistics that explain the natural causes of demand and supply for the financial transaction.
FUNDAMENTAL CHANGE (SPREADS WIDEN): In the event of a critical economic release or some information of equal import, the market liquidity dries up and the spread becomes wider.
Even after the release of such an information, the market trades at a wider spread till the time traders are able to absorb the implication of the release and are able to price the currency appropriately. Release of Trade Deficit number may result in the market quoting 1.1997/07
LARGE VOLUME (SPREADS WIDEN): There are occasions when large customers like to buy or sell a currency in a chunky lot. In this case, the market maker builds in the premium in the spread for the time it would take him to neutralise his position given the volatility of the currency. For example, for a USD 30 mio quote 1.1995/10
TINY VOLUME (SPREADS WIDEN): As mentioned earlier the market maker establishes the spread on a currency based on the processing cost of the trade and the market risk assumed.
However, when forced to quote for a smaller amount, he would widen the quote to compensate for the smaller profit he is expecting to make from the smaller transaction. It should be noted that he in turn would not be able to offload the transaction to another market participant for a similar reason.
In the stock markets, such transactions are called odd-lot transactions. In most instances, the person calling would indicate his side, EUR 0.1 mio buy and the quote would be 1.2007.
CREDIT CONSIDERATIONS: All financial institutions are not created equal and as such, financial institutions in developing countries cannot expect to be treated the same as the ones in better graded countries.
QUICK CONCEPTS:
-- G7 currencies bid/offer between 2/5 pips
-- Acceptable size trade between 1 - 10 million in most centres
-- Information uncertainty or large-size would increase the spread from 2 to 3 times the normal spread.
-- Absolute quote is based on the trader's position and view.