What is the spread?
Despite sounding like something you might put in a sandwich, in financial terms, the spread definition is the difference between the bid price and ask price of an asset, security or commodity. It is a term that is used across the board in the financial industry. In stock trading it’s the difference between the ask and bid prices for a stock. In futures trading, it relates to the difference in price for the same commodity between delivery months. In trading of bonds, it refers to the difference in yield between bonds of different maturities and similar quality or vice versa.
In short, the spread definition is the difference between two related quantities. To investors, these differences can provide a trade opportunity.
Where have you heard about spreads?
You’ll probably have heard about spreads in the financial news. They are sometimes cited as a sign that the market is slowing down and there has been a decrease in liquidity. In etymological terms, the word “spreadsheet” is broken down, literally into meaning “a sheet showing the spread”. Anyone who has ever sat down to work out their monthly finances will have ended up with a spread in all but name in the difference between monthly income and expenditure. If you’re a betting or gambling person, then the spread is also a term used in poker, and also when placing bets on sports events.
What you need to know about spreads…
In a general sense, the spread definitionis simply the difference between two measures.
- In stock markets, it is the difference between the ask or offer price that a trader is willing to pay when buying shares and the price that they intend to sell it at.
- In foreign currency markets, the same principle applies. Spread is the cost for traders and the profit for dealers.
- The spread has a slightly different meaning in bond markets and similar fixed-income securities. Whilst still denoting difference, it refers to the difference in yields on similar bonds. For example, if the yield on a US Treasury bond is 5% and that of a UK Government bond is 6%, then the spread is 1%. With bonds it can also refer to the difference in yields on securities of different qualities but with the same maturity date. For example, a high-yield bond that pays 9% and a US Treasury bond of 5% has a spread of 4%.
- In futures, the spread is the difference between prices for the same commodity or security at different delivery dates. For example, in wheat futures contracts, there is generally a spread between the price of January wheat futures contracts and October ones. Changes in the market, in this case the wheat market, cause the spread to narrow and widen.
The bid-ask spread
The bid-ask spread, also known as the bid-offer spread or buy-sell spread, refers to the difference between the prices that were quoted, either in an order book or by a market maker, for the immediate sale (bid) and the immediate purchase (ask) of an asset. The assets in question could be stocks, options, futures contracts or currencies.
For example, if the ask price for a stock is £12 and the bid price for the same stock is £10.50, then the bid-ask spreadfor that stock is £1.50.
The size of the bid-ask spread in a security is one of the measures used to check market liquidity. Some markets have more liquidity than others. The currency market, for example, is generally considered to be the most liquid in the financial world. The currency market’s bid-ask spread is very small, around 0.001%, meaning that the spread can be measured in pennies or fractions of pennies. Small-cap stocks and other less-liquid assets may have a spread of 1 or 2% of that asset’s bottom ask price.
A spread trade, or relative value trade, is what is happening when an investor simultaneously buys and sells two related securities that have been bundled together as a single unit. Each transaction in a spread tradeis known as a ‘leg’.
The idea behind spread trading is to create a profit from the spread (the difference) between the two legs. Usually the legs of a spread trade are futures and options.
The reason why spread trades are done as a single unit is threefold. Firstly, it ensures the synchronised completion of the trade. Secondly, it eliminates the risk that one leg will fail to be executed. And thirdly, it enables the trader to take advantage of the spread as it narrows and widens, instead of being attached to the price fluctuations of the legs.
There are three main types of spread trades:
- Calendar spreads: These are undertaken based on the expected market performance of an asset or security on a specific date, against the asset’s performance at another time. For example, January wheat futures and October wheat futures
- Intercommodity spreads: These reflect the economic relationship between two comparable but different commodities. For example, the historic relationship between silver and gold prices
- Option spreads: These can be somewhat complicated. Basically, it comes from the buying and selling of the same stock but at different “strike points”
Spread trades allow investors to utilise market imbalances to make a profit. A relatively small investment can be used to make a large profit. Spread trades are also sometimes used as a hedging strategy.
The yield spread, or credit spread, refers to the difference between the rates of return that were quoted in an order book or by a market maker between two different investments. It is often used as an indicator of risk for one investment product compared to another.
The expression “yield spreadof X over Y” is used by some financial analysts to refer to the annual percentage ‘yield to maturity’ difference between two financial instruments, X and Y.
In order to create a discount on the price of a security, so it can be matched to the present market price, the yield spread and a benchmark yield curve must be added together. This newly adjusted price is known as the option-adjusted spread and is typically used with bonds, interest rate derivatives, options and mortgage backed securities (MBSs).
The Z-spread, also known as yield curve spread, Z SPRD, or zero-volatility spread, is used together with MBSs. It refers to the spread that results from the use of a zero-coupon Treasury yield curve, which is needed for the discount of a pre-determined cash flow schedule to achieve its present market price.
The credit spread refers to differences in yield between a debt security and a US Treasury Bond that have the same maturity but differing quality.
The term is also used as an options strategy whereby a low premium option is bought, and a high premium option is sold on the same underlying asset.