What is the spread in crypto trading?

• The concept of market efficiency
• The importance of the spread
• Artificially adding a Spread

Trading crypto is often compared to betting, because of the element of risk, but there is actually a more fundamental similarity in the way both markets work. In betting there is an implied cost of placing a bet called a margin, which in trading is called the spread. Knowing what a spread means is essential for becoming a better crypto trader.

Many people trading crypto are looking to uncover the next big thing before it blows up. The problem is that when a cryptocurrency first launches there will be very little trading activity. In trading terms this is called an inefficient market, because there will be a big gap between the price that people want to buy, and the price that people want to sell. That gap is known as the spread.

The concept of market efficiency

Imagine you launch a new crypto called Super Coin, and mint 1 million coins. You might value the coin at €1 and want to sell 10% at that price, but no one is aware of your new coin. Slowly, a few people show an interest, but with varying levels of confidence, so there might be orders to buy like this:

You are the only seller right now, so unless A is willing to increase their offer your only option is to take offer A, and sell at €0.75 euros. 

Offers to Buy Super Coin	Offers to Sell Super Coin
(A) 100,000 @ €0.75	(You) 100,000 @ €1
(B) 100,000 @ €0.70
(C) 100,000 @ €0.65

Having bought at €0.75, (A) can now only make a profit by selling 100,000 Super Coin to someone else above that price e.g €0.76 (also known as a Bid) . Right now, unless B/C change their opinion, the best offer to buy is €0.70, and any new market entrant only needs to offer €0.71 to be the best offer (known as an Ask) which is still well below what the only Seller (A) is willing to accept. So the market looks like this: 

Offers to Buy Super Coin	Offers to Sell Super Coin
(D) 100,000 @ €0.71	(A) 100,000 @ €0.76
(B) 100,000 @ €0.70
(C) 100,000 @ €0.65

With so few market participants, the only way that anyone can make profitable trades is buy/sell at available price and/or wait for more people to make more Asks/Bids. This is what is known as adding liquidity to the market, which closes the gap between the highest price someone is willing to buy and the lowest price someone is willing to sell at - this is what the term Spread refers to.

The Spread, therefore, adds an implied cost to a trade, which is the cost of making a subsequent profit. You can calculate the Spread like this:

Spread = Lowest Asking Price - Highest Selling Price

As a %: (Spread/Lowest Asking Price)*100

The spread is the gap between the highest price someone wants to buy at and the lowest price someone is willing to sell at, and needs to be factored in to the explicit commission charged for executing the trade.

The importance of the Spread

The spread is the gap between the highest price someone wants to buy at and the lowest price someone is willing to sell at, and needs to be factored in to the explicit commission charged for executing the trade.

Where there is an efficient market - such as major cryptocurrencies - with a lot of people both wanting to buy and sell in equal amounts, that gap will be very small. 

It is an implied cost because you only feel the effect in subsequent trades, as the crypto you bought has to increase above the level of the Spread, rather than the price you bought at, in order for you to make a profit. 

As mentioned, the Spread for highly traded (liquid) cryptocurrencies is tiny - a fraction of one percent - but it does increase for more obscure coins, so it becomes relevant if you think you can make a killing trading the next Moonshot.

Artificially adding a Spread

Cryptocurrency exchanges work by bringing together buyers and sellers, and facilitating the exchange at the best available price for both sides. The spread is the natural consequence of the amount of available liquidity, and the exchange will incentivise big traders to come in and provide liquidity by reducing the commission as the amount traded increases.

But exchanges don’t have a monopoly on buying/selling crypto, they are willing to work with third-parties, brokers, who attract customers wanting to buy crypto, but don’t want to interact directly with the market. The broker can apply their own Spread, as a way to boost their profit, or offer a synthetic market called a CFD (contract for difference) which is just a synthetic version of the real market.  

This inflated Spread approach is what happens with the huge array of financial service Apps now offering the option of buying crypto e.g. Paypal, Robinhood, and  is the model that Coinbase uses; the real exchange where trades happen is Coinbase Pro.

The comparison with betting is relevant because the Spread is an implied cost, just as there is an implied cost of placing a bet, which the large majority of bettors are completely unaware of. It is the difference between the underlying probability of an event (fair/efficient odds), and the probability implied by the odds offered by the bookmaker. The best example being a coin toss:

Real probability: Heads 0.5 Tails 0.5
Percentage chance: 50% / 50%

Fair Decimal odds :Heads 2.0/Tails 2.0

Example Bookmaker odds: Heads 1.90/Tails 1.90
Implied Percentage chance: 53%/53%
Implied Probability: Heads 0.53/Tails 0.53

Betting markets offered by an exchange will tend toward the true probability and a fully efficient odds as liquidity increases. Just like cryptocurrency exchanges. betting markets offered by fixed odds bookmakers (which is the default) have an in-built margin, the cost of placing a bet, applied in the same way the crypto broker adds a spread to ensure a profit.

If you want to take trading or betting seriously you have to factor in the influence the spread has in longterm profitability.