The world of cryptocurrencies continues to expand with spread trading, spot trading, and even derivatives. Individuals within the sector are trading on the micromovements that take place within bitcoin and other digital currencies.
You see, significant and ambitious projects take on extraordinary levels of risk to accomplish different objectives. These objectives range from a decentralized world with open assets and accessible assets to more privacy across the web.
Digital assets and markets also intertwine because they offer a higher yield than the savings rate at banks around the world due to low central banking interest rates.
Cryptocurrencies seek to disintermediate money and many different industries. The disintermediation ambition begets many more projects and opportunities.
Traders will be there throughout the way to buy and sell digital assets through various trading forms. To be a professional trader, you must understand the difference between the different types of trades and make decisions accordingly.
Today we will discuss spread trading and how it matters in general and the cryptocurrency industry.
The Definition of Spread in Financial Markets
The term spread means many different things in finance. But one aspect is true, the underlying theme for all notions of spread is simple, and it refers to the variance among two price points in a financial concept.
The price spread can be in interest rates, in prices of a financial vehicle, or short term or long term yields.
Remember that the spread will always refer to the variance between two values in finance. You may notice that there is the bid/ask spread. This is the more popular spread in regular financial markets and in the cryptocurrency market.
Why is that? The answer is simple; exchanges employ the bid/ask spread in all trades. The spread is the price variance between the bid and the ask prices present within a stock, bond, or a digital currency. You will also find this in the long term and strong commodity markets.
The spread also will mean the variance in the trading positions. For instance, you can have long positions and a short position. You will notice that there is a gap between your two positions. That is the spread. People will call this the spread trade. This is the main one you will deal with in your cryptocurrency trading.
But there is also another notion of spread in finance, and that is in underwriting. For instance, when a company issues equities, an underwriter will underwrite the deal and do so at a more feasible price. The underwriter will then take those shares to the market at a higher price.
The spread is the variance in between what the underwriter paid and what they sold it for.
Finally, you will notice a spread in lending in cryptocurrencies and in the conventional financial world. The spread in lending is what it costs the lender to lend the money and what costs the borrower to borrow it.
Spread Trade
Professionals will refer to this as the relative value trade because of the way that it works. The simple idea with this trade is that you would purchase one financial asset, then sell another financial asset. The idea would be to do so in one package deal so as to gain value from the spread present within the trade.
Professionals will utilize the relative trade in the derivatives markets through traditional financial instruments or cryptocurrency instruments. Pro traders will expect these trades to work out in such a manner that they receive profits from the difference of selling one and buying one.
You will notice that these come with package prices or pairs in the futures markets to provide the financial instrument’s concurrent acquisition and divestiture. These individuals take part in this trade because they can minimize risks through the execution of the transaction.
Let us dive a little further into relative value or spread trade in the traditional and crypto world.
What Is Relative Value?
Relative value enables you to value a cryptocurrency or a financial asset by looking at other similar financial vehicles. Traders will look at the asset and think about what may be a better option and make a pair trade to sell one and buy another within the same category.
The main point is that one individual will conduct a relative value trade by assessing the worth of one in comparison to another one. If you make the right apples to apples comparison and trade wisely, you can profit.
Relative value imposes specific constraints that enable the investor to focus and think about the right trading decision.
Comprehending Relative Value
In traditional investing, you may look at the balance sheet, income statement, and the cash flow statement of a business. But in digital assets, you would look at technical analysis in bitcoin or other crypto assets and make trades accordingly.
The steps present within this process consists of:
- View comparable cryptocurrency assets by assessing market capitalization and general market sentiment between different crypto assets.
- View and chart how price can rise or fall for these crypto assets based on technical analysis and general market sentiment.
- Think and make a decision whether one asset is overvalued while the other is undervalued. For example, while bitcoin and ethereum are not apples to apples, bitcoin could have a flat growth while ethereum may explode upward. If you came to that decision, then you would sell bitcoin and buy ethereum.
- Remember that spread trades create value while viewing the widening or the narrowing of the spread. It isn’t about the prices of each unit but rather the spread itself. Remember that it is about the relationship between assets as opposed to the price increase.
- You will purchase or sell a spread if you have a viewpoint on the widening or the narrowing of the spread.
General Tips on Spread Trading
Here are few general tips on spread trading when you are conducting futures trades.
- Enter into tighter spreads if you have to pay commission
- If you buy a spread you are expecting it to go higher
- If you sell a spread you think it will go lower
- The beautiful aspect is that you can go long the market or sell the market
- If you pick the right direction, you gain
- You will input minimal currency to enter the trade and bet on the point difference
- Spread trades can vary in the holding period
- The longer you hold a spread trade, the wider the range of the spread should get
- You magnify the trade by the size of the trade and the size of the move in the trade
- Magnify it even more with leverage
Let us move on to the next spread trade iteration.
Spread Trade with Bid/Ask
The market spread is the width between the topmost bid offer and lowest level ask offer on the exchange order book. If we were to look at this simply we would state that the width is the variance between the price at which people are looking to divest a digital asset like bitcoin and the price at which market participants will acquire a digital currency.
Let’s break it down even more. Let us say that you want to buy Ethereum from a willing seller. You would ask the person to sell the Ethereum for $ $1,000. They might counteroffer with $1,500.
The variance between your bid to purchase Ethereum for $1,000 and another person’s inquiry or asking to sell Ethereum for $1,500 is what the market calls the spread in the bid/ask scenario.
Let’s take this situation over to a cryptocurrency entity where the order book consists of over thousands of unseen people setting prices by inputting their bids and where people are willing to sell Ethereum.
Those who are willing to sell at the lowest price level and those interested in buying at the highest price level are on opposite spectrums.
Let us take a look at the concept of the calculations that go into the market spread.
If you glance at an order book on an exchange like Binance you can see the lowest ask price and the highest bid price at that point in time. The bid price could be $16,000 while the lowest ask price may be 16,000.02.
How you calculate the spread
- Look at the topmost bid price and the lowest ask price.
- Subtract the topmost bid price from the lowest ask price.
- The formula to calculate the spreads is lowest ask price minus the highest bid price.
$16,000.02 – $16,000 = 0.02.
You will see the quote currency in the trading pair ETH/USD is used. The quote currency can vary based on region and setting. The quote currency will let you see price values in that denomination.
Those who want to have more information will view the percentages involved in the spread. Recall that percentages help you to determine market depth.
How do you calculate the percentage spread?
You divide the spread you noted above divided by the lowest ask price and then multiply that by a hundred.
What’s the Value of Market Spread in this Trading Strategy
The market spread matters because it can impact your trading performance. You want to look at the bid/ask spread in addition to other costs involved in the process of trading.
If you spend some time and ponder on this matter you will notice that market spread is crucial in improving your performance. That is right. Fees can come secondary in decreasing your performance.
One thing we have seen is that a large portion of backtesting tools do not take into account the aspect of market spread in the plotting of trades. That is a huge problem because this lack of data can provide significant market performance pain.
You may think that one strategy works out well by backtesting but will then realize that the market spread is a large factor that will affect the gains.
Let us take an example
Bitcoin has the highest bid offer at $30,000 while the lowest ask offer is $33,000. In this situation, the spread is $3,000.
We would calculate this and note that the spread is at a higher percentage. That is something that we think can move the needle and is something we must account for as we make decisions.
If one were to purchase bitcoin at $33,000 at the lowest ask offer, we would have to wait for the market to become more enthusiastic. That means we would patiently wait for the highest bid price to get to $33,000.
We are taking a great bit of risk in this equation as we must wait for the market to turn more positive. What happens if it becomes more negative?
Then you would be even a bigger hole.
If your objective is to turn a profit, you should make sure to account for the market spread and act accordingly. The bid and ask price matters. Factor in fees: You will find out that you are in a world of hurt if you buy at the wrong time.
But what if we see that there were tighter spreads? That would bring us massive value. Imagine that bitcoin is at $40,000 bid offer and the lowest ask offer is $40,000.02. The percent spread is very low, and the bid price would only have to rise by just a small value to earn gains.
From a theoretical standpoint, we may be able to earn more from tighter spreads that large ones due to the lower level of risk involved in the process.
We want to make sure that the asset performance doesn’t have to be excessive for us to earn substantial or at least incremental gains. The more we expect and the more risks we take the larger the chances of loss.
Tighter spreads equal more liquidity in markets.
Why Do People Enter Into Spread Trades?
The reason why you enter into a spread trading position is that you want to minimize risk. How do you minimize risk in a spread trade? The first way is that you accept a tradeoff. You will minimize risk in return for a lower upside.
Spread traders will balance out their risk and defend against volatility or potential asset declines while still holding onto the digital asset. The beauty of spread trading enables traders to state and control their risk.
These investors want to do aggressively better than the overall market, but they want to do so without risk-related issues. It can be either a trade for the long-term or the short-term while sticking to larger goals.