Bites Of Trading Knowledge #5

What is the bid-ask spread? -

Bid-ask spread is the amount by which the ask price exceeds the bid price for a market. The bid-ask spread is the difference between the highest price that a buyer is willing to pay and the lowest price that a seller is willing to accept. An individual looking to sell will receive the bid price while the one looking to buy will pay the ask price.

A wide spread may indicate low supply or demand for a market at that point of time during the trading period, while a narrow spread would indicate sufficient supply and demand for a market meaning strong buying and selling competition is at play.

What is the role of a market maker in the financial markets? -

Market makers are market participants who ensure there is enough liquidity and volume of trading in the markets and offer to sell a market at the ask price and will also bid to purchase a market at the bid price to traders and investors.

How does the bid-ask spread relate to liquidity of a market? -

The size of the bid-ask spread from one market to another differs mainly because of the difference in liquidity of each market. Certain markets are more liquid than others and that commonly is reflected in their lower spreads. Price takers demand liquidity while market makers supply liquidity.

For example, foreign currency futures would have very low spreads during the trading day given the use of currencies as a medium of exchange to do business globally compared to live cattle futures, which relates more to businesses in the United States domestic market.


Diversification: Futures Spreads with Currency Futures -

A futures spread is usually created when one futures contract is sold simultaneously to the buying of a second related futures contract in order to capitalize on a discrepancy in price. Currency futures spreads combine the use of different currencies usually paired to the U.S. Dollar with the same contract month to express a relationship between the two currencies usually taking into account their strength or weakness relative to each other.

For example, the Singapore Dollar (USDSGD) may be seen to be strengthening (price movement is downward) while the South Korean Won (USDKRW) may be seen as being very weak (price movement is upward). To take advantage of this observation, we would want to buy Singapore Dollar (sell the USDSGD future) and sell the South Korean Won (buy the USDKRW future) and as a result eliminate the U.S. Dollar.

However, it must be noted that not all currencies are quoted in the same way like the Australian Dollar futures is quoted “AUDUSD”. It means then that to take advantage of a strong Australian Dollar and a weak South Korean Won quoted as “USDKRW”, an investor would need to buy both the AUDUSD future and the USDKRW future.

Diversification: Portfolio Risk Using FX Futures -

Individual investors taking a portfolio approach with managed futures and spot foreign exchange could be entering into emerging market currency positions including for example Hong Kong Dollar, Singapore Dollar or South Korean Won.

Depending on the view of each of the currencies in the portfolio, it could be constructed to eliminate exposure to the U.S. Dollar. However, there may be a time during which investors would like to introduce U.S. Dollar exposure and they could do so by using Mini U.S. Dollar Index ® Futures with a contract value of $10,000.

For example, the U.S. Dollar Index ® may be observed to be in a medium term uptrend and an investor may want to consider entering into a long position in the Mini U.S. Dollar Index ® Futures based on their strategy of choice and exit the position when either their profit target is achieved or their loss limits are triggered.

Source: ICE Connect

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TRADDICTIV · Research Team

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