The Spread Is the Price of Immediacy
The spread is not a fee, it is the price of being unwilling to wait — and its size in cents tells you nothing. What decides whether you can afford it is its size measured against the stop you are using. On the two instruments below, the same setup and the same discipline need a 50.8 per cent win rate in one and 67.5 per cent in the other, and only one of those is a number anything reliably achieves.
Prerequisites: Lesson 2, for depth and what it costs to walk it, and lesson 3, for the two costs of choosing an order type.
The spread is the difference between the bid and the ask. That is true, and on its own it is useless, because a penny is trivial in one situation and fatal in another and the number does not tell you which.
The annual figure, which is the wrong frame
Start with the arithmetic everybody eventually does. A 0.05 per cent spread on a $10,000 position is $5 a round trip. Fifty trades a month is $250; over a year, $3,000. Whether that is alarming depends on a number this example does not contain: divide it by your account, not by the position. Three per cent a year is a cost of doing business. Thirty per cent is the business.
It is a real number and it is worth computing once, because most people have never seen it. But it will not help you decide anything, because it says nothing about whether a particular trade is worth taking. For that you need the spread compared to something, and the something is your stop.
The ratio that decides it
Say your stop is one point away and the spread is a quarter of a point. Then the spread is 25 per cent of the distance you are risking. Not 25 per cent of the position — 25 per cent of the risk, which is the number your sizing is built on.
Work out what that does. Trade at one-to-one, so your target is also a point. A winner does not make a full point, it makes a point minus the spread. A loser does not cost a point, it costs a point plus the spread. Writing s for the spread as a fraction of the stop, breakeven is where
p × (1 − s) = (1 − p) × (1 + s)
Multiply it out and every term carrying both p and s cancels against its twin on the other side. What survives is:
breakeven win rate = (1 + s) ÷ 2
That is the whole thing. One division and one addition, and it holds for any instrument and any stop distance.
| Spread as a share of your stop | Win rate needed just to break even |
|---|---|
| 0% (no spread) | 50.0% |
| 5% | 52.5% |
| 10% | 55.0% |
| 25% | 62.5% |
| 50% | 75.0% |
| 100% | 100% — impossible |
What the table is actually saying
The same dollar spread is trivial against a wide stop and decisive against a tight one. Nothing about the instrument changed between the first row and the last; only your stop did.
So this is the arithmetic case against scalping with very tight stops, and it is arithmetic rather than opinion. Tighten the stop and you have not reduced your risk, you have raised the win rate you must find. At a quarter of your stop the market is asking you for 62.5 per cent before you make a penny — and a 62.5 per cent hit rate is not a small thing to ask for.
It also tells you which of your two problems to solve. If your spread-to-stop ratio is 5 per cent, the spread is not what is wrong with your trading and you should stop optimising it. If it is 40 per cent, no entry technique will save you, and the fix is a wider stop, a different instrument, or not trading that setup.
The same trade in two instruments
You have one setup, a stop you have decided on, and two candidate instruments.
The first is the index ETF from lesson 1, still quoted a penny wide at 512.30 and 512.31, and your stop is $0.60 away. s = 0.01 ÷ 0.60, or 1.7 per cent. Breakeven win rate 50.8 per cent. The spread is noise; go and think about something else.
The second is the $1.50 micro-cap from that same lesson, still quoted 1.48 and 1.55, and because it moves more you have set a stop $0.20 away. s = 0.07 ÷ 0.20, or 35 per cent. Breakeven win rate 67.5 per cent. Your setup does not win 67.5 per cent of the time. Almost nothing does.
Same trader, same idea, same discipline. One is a business and one is a donation, and the difference was decided by two numbers you can read off a screen before entering. This is the calculation lesson 12 turns into a ranking you can apply across every instrument you are considering.
What this does not settle
The formula assumes one-to-one reward to risk and that you pay the whole spread on the round trip. Change the payoff and the breakeven changes with it; use limit orders on both ends and you may pay less than the whole spread, at the cost lesson 3 describes. It also treats the spread as your only cost. It is not: commissions, financing and the slippage from walking past the quote all sit on top, and lesson 11 adds them.
Every s on this page is also built from the quoted spread, and lesson 2 showed what a quote is worth: on that book only 300 shares stood at the top of it. An order larger than what is resting there pays more than the number you divided by, so every breakeven in the table is a floor rather than a figure, and it sits further under the truth the bigger you trade.
And the fix this page keeps recommending is not free either. Told that s is 35 per cent, the obvious move is to widen the stop until it is not, and the arithmetic will duly improve. What the arithmetic cannot see is that a stop belongs where the trade is wrong, not where the ratio is comfortable, and a stop moved to flatter a formula loses more on every occasion it is hit. Lesson 21 puts the stop somewhere for a reason. Until then s is a number you can compute exactly and cannot honestly control.
And it says nothing about why a spread is the width it is, or why it changes during the day. That is a question about the person quoting it rather than about you, and it is what the next lesson is for.
A spread is only ever expensive relative to something. Divide it by your stop, and the number starts telling you what to do.
Problems
- Run the formula. An instrument is quoted 0.02 wide and you are using a 0.40 stop at one-to-one. What win rate do you need to break even? Now the same instrument with a 0.08 stop. State the two answers and say which of the two setups you would be willing to trade.
- Invert it. Your setup wins 55 per cent of the time at one-to-one. Rearrange
p = (1 + s) ÷ 2to find the spread-to-stop ratio at which your entire edge is gone. Then say what stop distance that implies on an instrument quoted 0.02 wide, and whether you would want to trade anywhere near it. - Your own trading. Take the last ten trades you made or planned. For each, record the spread at entry and the stop distance, and compute
s. What is your median? Using the table, what win rate is your own trading currently asking of you, and how does that compare to the win rate you actually have?
Sources. Harold Demsetz, “The Cost of Transacting” (Quarterly Journal of Economics 82, 1968), the paper that framed the spread as the price of immediacy rather than a fee. Larry Harris, Trading and Exchanges (Oxford, 2003), chapter 21, on measuring transaction costs against the trade rather than in isolation.
You can now price the spread against your own stop. The next lesson turns the question round and puts it to the person quoting. The answer has three parts: one fixed cost that sets the floor, and two risks that account for almost every time the number moves.
What a Fill Actually Is
The other cost of an order type, the one that never reaches your statement.
Read Lesson →Why Anyone Quotes At All
Why this number is what it is, and what makes it widen.
Read Lesson →Slippage and Impact
The costs that sit on top of the spread once your size passes the quote.
Read Lesson →What Should You Actually Trade?
This ratio, turned into a ranking across every instrument you might trade.
Read Lesson →Educational only. Trading involves substantial risk of loss. Not financial advice. Past performance does not guarantee future results.
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