The difference between the bid (sell) and ask (buy) prices of any instrument is known as the spread.
When the spread of a financial instrument is tight, meaning that there is only a small difference between the two prices, it is cheaper to trade. In comparison, if the prices are further apart, or the spread is wide, the instrument will cost more to trade.
Market liquidity has a significant effect on spread. During times of high liquidity, an instrument’s spread is typically low. The reason for this is that, as your trade will easily be matched, there is no need for transaction costs to be high. On the other hand, if liquidity is low, spreads will often widen significantly due to the difficulty in pairing your trade with another trader in the market.
For example, highly liquid instruments, like the EUR/GBP currency pair, often have very low spreads of less than one pip. In forex, a pip is the smallest increment in which a currency pair can move and is usually the fourth decimal place in the price of the pair (in pairs featuring the JPY, it is the second decimal place).
For example, the spread on EUR/GBP could be 0.8 pips, meaning the buy price for the currency may be 0.87887, while the sell price is 0.87879. This means that the pair costs very little to trade.
In comparison, an exotic currency pair that has low liquidity, like the GBP/ZAR, can often have a significantly higher spread. As the trading volume on the South African rand (ZAR) is generally very low, it can be difficult to match orders on the market. This means that, for example, the buy price could be 18.01400, while the sell price is 17.99300, giving a spread of 210 pips and making the pair more expensive to trade.
The significant effect that liquidity has on trading costs and market volatility is one of the main reasons why, for beginners entering the market for the first time, it is recommended to stick to trading the most liquid instruments.
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