What is a spread in stocks, and why should you care? As an investor, understanding spreads is essential to making informed decisions. It can impact the result of both short term trading strategies and long term investment plans.

In this article, we'll dive into what spreads are and how they can affect your investment strategies. We'll also explore the potential risks and benefits of each approach. Whether you're a novice or seasoned investor, this is a must-read guide to navigating the world of spreads in stocks.

What is a spread in stocks?

When we talk about the "spread" in stocks, we refer to the gap between the buying price and selling price. The buying price is called the "bid" price, which is what a person is willing to pay for a stock. On the other hand, the selling price is called the "ask" price, which is what someone is willing to sell the stock for. The difference between the two is called the spread.

The term "spread" comes from the early days of the stock market. During these times, traders would physically meet on the floor of the exchange to buy and sell stocks. To keep track, they would spread a paper sheet with the different prices to buy and sell stocks. This was done to easily compare the prices and decide which stocks to trade based on the difference between them.

They would then shout out the highest price they would pay to buy a stock ("bid" price), and the lowest price they would sell a stock for ("ask" price). The difference between the two became known as the "spread." Today, we still use this term to talk about the difference between the bid and ask prices of a stock.

The spread can affect the stock's price by showing how much people want to buy or sell it. If more people want to buy the stock than sell it, the spread is wider and the price may increase. If more people want to sell the stock than buy it, the spread is narrower and the price may drop.

Example what a spread is in stocks

For example, you want to buy shares of a company called ABC Inc. (note: this is a made-up company for illustrative purposes). The current bid price is $10, while the ask price is $10.50. This means that you can buy the shares for $10.50 each. But if you want to sell them, you'll have to do so for $10 each. The difference between the bid and ask price is called the spread, which in this case is $0.50.

To further this example, if you buy 50 shares at the ask price, it would cost you $525 ($10.50 x 50 shares). But if you were to sell the same 50 shares at the bid price, you would only receive $500 ($10 x 50 shares), which means you would lose $25 due to the spread.

Understanding the spread is important for investors because it can impact the price at which they buy or sell a stock. A wider spread can make it more expensive to buy a stock, while a narrower spread can make it easier to sell a stock at a good price.

The spread is just one of many factors to consider when investing in stocks. It's important to keep in mind that it can vary widely depending on the stock and the market conditions. It's also worth noting that spreads can have different impacts on short term and long term investors.

Let's explore these differences so you can make well-informed decisions to help you reach your investment goals, especially if buying Australian shares is one of them!

How spreads can affect the investing strategies of short term investors

As we discussed earlier, spreads are the difference between the bid price and the ask price of a stock. Short term investors who buy and sell stocks quickly to make a quick profit are particularly influenced by spreads.

Here are ways that spreads can affect the strategies of short term investors:

1.Transaction costs. If you're planning to buy and sell stocks quickly, you need to watch out for spreads. These are the extra costs you'll have to pay when buying or selling stocks. Short term investors need to be careful because spreads can increase their transaction costs. This means that they may have to pay more to buy a stock and receive less when they sell it.

2.Liquidity. Spreads can also impact the liquidity of a stock, which refers to how easy it is to buy or sell a stock quickly without affecting the price.

When spreads are wider, a stock may not be as easy to buy or sell quickly without affecting its price. This can make it difficult for short term investors who want to quickly buy or sell stocks to follow their trading plans.

3.Profitability. Finally, spreads can impact the profitability of short term investors. If a stock has a wider spread, it may take longer for short term investors to sell it and make a profit. This can slow down their earnings and might affect how much money they make overall.

So, it's important for short term investors to consider spreads when making their investment plans. Understanding spreads and how they can affect your investments can help in making smarter choices and potentially increase your profits.

Impact of spreads on short term investing strategies — risks and drawbacks

When it comes to short term investing strategies, it's important to be aware of the potential risks and drawbacks that come with them. In addition to the aforementioned transaction costs, short term investors need to be especially cautious of the following spread risks:

1.Market volatility. Short term investors need to be aware of market volatility. The market's volatility can lead to wider spreads, which makes it more difficult to buy and sell stocks at the desired prices.

2.Time constraints. Short term investing involves buying and selling stocks quickly. But, when spreads are wide, it can take longer to complete transactions. This can cause problems for short term investors who may not be able to fulfil their strategy.

3.Competition. Short term investors are often competing with other investors who are also looking to make quick revenue. This competition can drive up spreads and reduce potential profits.

4.Limited options. Short term investors who focus on spreads may find themselves limited to certain types of stocks or markets. This can lead to missed opportunities and a lack of diversification in their portfolio.

So, to sum it up, short term investing strategies based on spreads can potentially make you money. But it's essential to know about the risks and downsides involved, and to consider the factors mentioned above. To make good choices and avoid taking too many risks, it's crucial to have a solid understanding of the market and how prices can move.

How spreads can affect the investing strategies of long term investors

Long term investors, who aim to generate capital gains over a period of years, are also affected by spreads. Instead of making frequent trades like short term investors, their strategy is focused on buying and holding stocks. At Pearler, our investing community largely favours a long term approach.

If you plan to invest in the long term, you don't have to worry as much about spreads compared to day traders. Long term investors hold on to their investments for a longer time, so the cost of investing is spread out over that period. This means that the effect of spreads on their investment returns is not as significant compared to day traders, who make frequent trades.

But, spreads can still be a factor for long term investors. Here's how:

1.Cost of trading. One factor that affects the cost of trading is the spread. For long term investors, the effect of the spread on investment returns is not as critical compared to day traders.

But, even small differences in price can add up over time and affect investment returns. So, it's important for long term investors to be aware of spreads and how they can impact their returns in the long run.

2.Liquidity. When a stock is liquid, it means there are plenty of buyers and sellers willing to trade at any time. This is important for long term investors because they want to make sure they can sell their shares when they need to without any issues.

When there is low liquidity, the spread can be wider, meaning the difference between the buying and selling price of the stock can be bigger. This can impact long term investors, who may pay more when they buy and pocket less when they sell.

Take note, though, that long term investors generally avoid selling their shares until they reach their financial independence target.

3.Volatility. For investors who hold their stocks for a long time, it's normal to experience ups and downs in the market. But if you're a long term investor, you can use this to your advantage by waiting for the best time to buy or sell your stocks. However, keep in mind that this approach clashes with some long term investing strategies .

It also pays to be informed about market volatility if you want to invest in companies with steady growth. It's important to keep an eye on the market, so you can make informed decisions that align with your investment goals.

4.Bid-ask price. Long term investors can also use spreads to their advantage by paying attention to the bid-ask price. Knowing the difference between these prices can help them make better choices on when to buy and sell their shares.

5.Market conditions. Lastly, long term investors should keep an eye on market conditions when looking at spreads. When the market is unstable, spreads may widen a lot, which can affect their investment plans. It's necessary to think about the possible risks and benefits of investing in a stock with a wider spread during uncertain times in the market.

Impact of spreads on long term investing strategies — potential benefits

Earlier, we discussed the potential risks and drawbacks of short term investing strategies in the context of spreads in stocks. Now, looking at the other side of the coin, let's explore the potential benefits of long term investing strategies in the same context.

Spreads matter less over the long term. If you're planning to invest for a long time, you don't have to worry too much about small changes in spreads.

This means they can avoid the costs associated with frequent buying and selling, such as brokerage fees and taxes. It's important to understand the implications of these costs and plan accordingly by using record keeping and calculating tools.

As a long term investor, you can focus more on the big picture and the overall growth of your investments

So, the "spread" in stocks is the difference between the price someone is willing to pay for a stock (the bid) and the price someone is willing to sell it for (the ask). This difference can affect how both short and long term investors make their investment decisions.

Short term investors may find it challenging to make a profit due to the wider spreads and increased trading costs. For long term investors, spreads don't have as much impact, and they can benefit by holding onto their investments over time to see growth.

In the world of investing, there is no one strategy better than the other. It all boils down to your investment goals and risk tolerance. As such, it pays to know how to choose between investing strategies .

But, it is worth looking into how a long term investing approach can have its benefits. By being patient and disciplined, you can create a mix of stocks that can grow over time and help you achieve your financial goals.

Investing can be a long term game, whether you're just starting out or refining your strategies. By staying focused on your goals and sticking to your plan, you can achieve success over the long run.

Happy investing!