What is the spread in crypto trading?
Cryptocurrency trading is often compared to gambling due to the risk factor, but in reality, there is a more fundamental similarity in how both markets work. In betting, there is an implied cost associated with placing a bet, called the margin, which is known in the trade as a spread. Knowing what the spread means is essential to becoming a better cryptocurrency trader.
Many people who trade cryptocurrencies want to find out about the next big thing before it explodes. The problem is that when a cryptocurrency is first launched there is very little trading activity. In trading terms, this is called an inefficient market because there is a big difference between the price people buy and the price they sell.
The concept of market efficiency
Imagine launching a new cryptocurrency called Super Coin and minting one million coins. You can value a coin at 1 euro and want to sell 10% for that price, but nobody knows about your new coin. Slowly some people are showing interest, but with varying degrees of confidence, so such buy orders may come.
You are currently the only seller, so unless A is willing to raise his offer, your only option is to accept A’s offer and sell for $0.75.
After buying for €0.75 (A), a profit can now only be made by selling 100,000 supercoins to someone else above this price, for example €0.76 (also known as a bid). Currently, unless B/C changes his mind, the Best Buy Offer is $0.70, and each new entrant only needs to bid $0.71 to be the Best Offer (known as an Ask), which is still well below the below the only offer. Seller (A) is willing to accept. So the market looks like this:
With so few market participants, the only way anyone can trade profitably is to buy/sell at the available price and/or wait for more people to ask/bid. This is called adding liquidity to the market, bridging the gap between the highest price someone is willing to buy and the lowest price someone is willing to sell.
This is why the Spread adds a supposed cost to the trade, which is the cost of making a profit later on. You can calculate the Spread as follows:
- Spread = Lowest Selling Price – Highest Selling Price
- As a percentage: (spread/lowest asking price)*100
The importance of diffusion
The spread is the difference between the highest price someone is willing to buy at and the lowest price someone is willing to sell at, and should be factored into the specific commission charged for executing the trade.
Where there is an efficient market – such as major cryptocurrencies – and many people want to buy and sell at the same time, the difference is very small.
It is an assumed cost, as you will only feel the impact on subsequent trades, as the cryptocurrency you bought must rise more than the price at which you bought it to make a profit.
As mentioned, the interest on commonly traded (liquid) cryptocurrencies is small – a fraction of one percent – but it increases on more obscure coins, so it becomes relevant if you think you can make a great trade during the next Moonshot.
Artificially increases the spread
Cryptocurrency exchanges bring buyers and sellers together and facilitate the exchange at the best possible price for both parties. The spread is a natural consequence of the amount of liquidity available and the exchange encourages large traders to come in and provide liquidity by lowering the fee as trading volume increases.
But the exchanges don’t have a monopoly on buying/selling cryptocurrencies, they are willing to partner with third-party brokers which attract customers who want to buy cryptocurrencies but don’t want to interact directly with the market. A broker can use their spread to increase their profits or offer a synthetic market called a CFD (contract for difference) which is just a synthetic version of the real market.
This widespread mainstream approach is what is happening with a wide variety of financial services applications that now offer the ability to buy crypto payments, for example Paypal, Robinhood and it’s model used by Coinbase; the actual exchange where the transactions take place is Coinbase Pro.
The betting comparison is relevant because the spread is an assumed cost, just like placing a bet has implicit costs that most bettors aren’t fully aware of. It is the difference between the underlying probability of the event (true/actual odds) and the probability of the odds offered by the bookmaker.
- True Prob: heads 0.5 tails 0.5
- Percentage chance: 50% / 50%
- Reasonable decimal odds: Heads 2.0 / Coins 2.0
- Example bookmaker odds: heads 1.90/tails 1.90
- Assumed Percentage Chance: 53%/53%
- Implied probability: heads 0.53/tails 0.53
The gambling market offered by the exchange tends towards true odds and fully effective odds as liquidity increases. Similar to cryptocurrency exchanges. the betting markets offered by fixed odds bookmakers (which is the default) have a built-in margin, the cost of placing a bet, which is applied in the same way that a cryptocurrency broker adds margin to guarantee a profit.
If you want to take trading or gambling seriously, you need to consider the impact of the difference on your long-term profitability.