Are Wide Spreads & Greedy Market Makers Killing Your Performance?

10th Jan by Jack Corsellis

11 comments 725 reads

Post meant as 'food for thought' and something I wish I'd read 10-years ago as rarely are the effect of spreads discussed!

For an active swing trader like myself, spreads and liquidity matter... a lot. Just because I'm a UK resident, doesn't mean UK listed stocks are best for my style of swing trading. The familiar is not always best!

Take Yu (LON:YU.) group for example. It's one of the strongest stocks in the UK market from a relative strength perspective, has strong growth forecasts, and several impressive fundamental metrics like an ROE of 42.6%.

Moreover, it has the outline of William O'Neil's favourite chart pattern, a Cup with Handle and is nearing a potential 'breakout point'.

On the face of it, all seems well. Until one factors in spreads (and liquidity).

Note the 1hr chart and the difference between the current bid and ask.

The Bid is £12.50 and the Ask is £12.80 (at time of writing).

Investors/traders pay the Ask price when they buy a security and receive the Bid when they sell.

The current spread (difference between the bid/ask) is 2.34%.

A 'round-trip' in spreads is 4.68% that investors/traders are 'giving up' to market makers. Why? Because they pay the spread when they get in and the spread when they get out. Double whammy!

Not to mention stocks with higher spreads are often those where slippage occurs due to a lack of liquidity (willing buyers) when you want to get out at your stop loss level. So you think you're getting out at X but actually you get filled at Y which could be another 2, 3, 4% lower than your intended exit price.

For myself I'm trying to maintain an average loss of circa 3% on losing trades over a large sample size. Spreads this wide make the stock a no go because tight risk management is near impossible.

For illustration purposes of a more liquid UK stock please stroll down to see Tesco (LON:TSCO).

The Bid is £2.966 and Ask is £2.968 (at time of writing). The current spread difference is circa 0.07%.

For an active swing trader not wanting to line market makers pockets, this is much more appealing. However, the UK market unfortunately is a 'small pond' to be fishing in for this type of liquidity - especially if one wants the stock…

Unlock with Email

Unlock with Google

Already have an account?
Login here

Rusty2

10th Jan

I have commented on spreads recently on other posts, on here. Prices are not even within the spread, I seen several this year. Trading at times is unavailable or one or the other. Even on mid caps the spreads can be wide. I agree about the US markets, so easy to buy and sell, spreads are very narrow.

Benson212

I agree, you need a different strategy if you're investing in the UK stock market. Nearly all the alpha sits in small cap stocks with wide spreads and poor liquidity, so you need to take a medium/long term approach. You'll need to aim for at least 20%-30% gains on your winners to justify paying the spread, playing for anything less can get you into trouble.

When I trade UK small caps, I go more "old school" William O'Neil style, using the weekly chart with the aim of holding for the majority of the cyclical bull.

But generally speaking, I have transferred most of my capital out of Britain. The U.S. has better liquidity, more opportunities & IPOs and less fraud (looking at you Cirata (LON:CRTA)!). My US portfolio significantly outperforms my UK one every year (last year especially), so I am going to slowly sell down my UK investments and move it into the U.S. Looking at the lacklustre IPO pipeline in London, I doubt I will be returning anytime soon!

turbo

Benson, would be good to know how you research US stock, and whether you use Stockopedia for this.

Sure. I use Stockopedia for my US research. I screen for 99 Momentum rank stocks and use a trend template inspired by Mark Minervini to ensure the stocks have absolute momentum. I then hold a concentrated portfolio of 5 stocks, rebalancing when the momentum rank falls below 95 or the absolute trend breaks.

Breakout Trader

I'm actually in Yu at the moment with a spreadbet, so I can illustrate this issue.

My chart is set to show the 'Ask' price.

You can see that while the stock has moved up from my buy point, the position itself is still losing, purely due to the spread.

I also focus mainly on the US markets for this reason, and for short-term / swing trading, many of the small cap UK stops are out of bounds, particularly if running tight stops.

One useful tip is to use the Bid-Ask spread filter if screening in stocko, I typically filter out any stock with a spread greater than 150/200.

donald pond

Its all a self fulfilling prophesy. As more people trade online they see the attractions of international markets, which reduces liquidity in the UK markets, which increase spreads further, which drives people to better markets. Even a stock like Burford Capital (LON:BUR) which is by no means a small cap has a smaller spread in the US than the UK. Then you add in stamp duty on many stocks and the market is dying on its feet.
There is a global market for stocks and it seems the UK is the last country to realise this.

Abercrombie & Fitch Co (NYQ:ANF) looks good.

Not really used my Minervini screen for US stocks.

pka

Hi Jack,

I agree with your general argument about wide spreads in the UK stock market making trading less profitable. However, you also wrote:

"The Bid is £12.50 and the Ask is £12.80 (at time of writing).
Investors/traders pay the Ask price when they buy a security and receive the Bid when they sell.
The current spread (difference between the bid/ask) is 2.34%.
A 'round-trip' in spreads is 4.68% that investors/traders are 'giving up' to market makers. Why? Because they pay the spread when they get in and the spread when they get out. Double whammy!"

Actually a trader only pays the spread once in a 'round-trip', not twice, because he pays the Ask price of £12.80 when he buys and receives the Bid price of £12.50 when he sells (assuming Bid and Ask prices don't change). So, in your example, the spread is £0.30 / £12.50, or 2.4%. The trader also has to pay 0.5% stamp duty when he buys plus stockbroker's commission, so the cost of the 'round trip' in your example is at least 2.9%. But that's less than 4.68%.

Jack Corsellis

11th Jan

I view it with a different logic as I've 'given up' circa 4.68% in spreads during the 'round-trip' process. I pay the 'premium' spread when I get in, and the 'discount' spread when I get out.

Either way, it's a turnoff.

Good point on 0.5% stamp duty.

Just looking at Goodwin (LON:GDWN) this morning about 10am, a £400m mcap. Stocko. has it up 6.7%, checked with my broker, no movement. Last trade was a buy, if next trade a sell, it would go back 0%. Just shows the spread in the market.

Stocko. should use mid prices, their prices are very misleading.

WarrantStar

27th Jan

PKA is completely correct in his comment. The real round trip spread in your example is 2.34% . This is a question of basic mathematics. It might be fair enough to say that you are paying it on two occasions, i.e. when you buy and when you sell. But if you want to view it that way, then it would be correct to say that you only pay half the spread when you buy, and pay the other half of the spread when you sell. It erroneous to say that the round trip spread is actually 4.68% when the reality is that it is 2.34%. However, I do agree with you that these spreads do represent real and significant costs to potential investors.

Are Wide Spreads & Greedy Market Makers Killing Your Performance?

Unlock the rest of this article with a 14 day trial

About the Author

Jack Corsellis

11 comments

Unlock the metrics for all these stocks and more...

Unlock the metrics for all these stocks and more...