Spread 101
This post is for general intuition on the meaning of spreads.
The spread is the distance between the lowest ask and the highest bid on a specific asset in an exchange order book. The smaller the spread the more the price is meaningful. Why?
“Imagine it is 1995 and you arrive in a foreign country and you don’t know the exchange rate. The taxi driver from the airport tells you, “For every 1 dollar you give me, I’ll give you 70 local coins. If you want to change back the local coins I’ll give you only 1 dollar for 100 coins. So the difference, (or the ‘spread’) is the difference between 70 to 100.
This is a bad deal. How do you know? Because the spread is too big.
So if I want to buy, I don’t like the spread to be so big.
If he says “I’ll buy 1 dollar for 70 local coins and sell 1 dollar for 71, now I can say- ‘You know what, OK.” You feel like you’re not getting ripped off.
I will try to not purchase this coin if the spread is 70 to 100. Even if I believe this coin is good. If I see the spread the market makers are offering is buying at 70 and selling at 100, I’ll say ‘no thank you’ and look for something better.
When there’s a big spread, you don’t know the real price. If you’re told ‘I’m buying at 80 and selling at 81’, that’s a sign the price is real and it allows me to understand I’m being ‘hurt’ just a little, by half a percent.
By market making with a tighter spread, we allow people who want to take part in a project to really do so.”
