What is the spread?

What is spread?

Despite sounding like something you might put in a sandwich, the spread definition is the difference between the bid price and ask price of an asset, security or commodity. 

What is spread in finance? The term 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. 

Key takeaways

Understanding spreads

Spreads 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. Spreads  are also a term used in poker and when placing bets on sports events.

In a general sense, the spread is 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.

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.

Types of spreads

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 is £10.50, then the bid-ask spread for 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. 

For example, the currency market is generally considered 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.

Spread trades

A spread trade, or relative value trade, is what happens when an investor simultaneously buys and sells two related securities bundled together as a single unit. Each transaction in a spread trade is known as a ‘leg’.

The idea behind trading spreads is to create a profit from the spread 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. First, it ensures the synchronised completion of the trade. Second, it eliminates the risk that one leg will fail to be executed. And third, 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. E.g., the historic relationship between silver and gold prices.

• Option spreads. These come 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.

Yield spread

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 spread of X over Y’ is used by some financial analysts to refer to the annual percentage ‘yield to maturity’ difference between two financial instruments.

Option-adjusted spread

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 (MBS).

Z-spread

The Z-spread, also known as yield curve spread, Z SPRD, or zero-volatility spread, is used together with MBS. 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.

Credit spread

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.

Strategies for managing spread costs

Now that we have explained spreads and the different forms they can come in, let’s take a look at how the cost of these spreads could be managed.

1. Balance trades. One way to potentially manage spread costs is to balance trades with both buy and sell orders. This could help minimise the cost of the spread.

2. Limit orders. Using limit orders when trading can help you to control the spread costs as you can set the price you’re willing to pay for a certain asset.

3. Multiple brokers. Using multiple brokers could help traders manage their spread costs by letting them compare different brokers’ spreads and choosing the most suitable option.

4. Low-cost trading platforms. Many online trading platforms offer low-cost trading, which could potentially help traders reduce their spread costs.

5. Low leverage. Using low leverage may also help reduce spread costs. The lower the leverage, the lower the spread costs.

Advantages of trading spreads

• Reduced risk. Spread trading involves taking positions in two different markets, which may help to reduce overall risk. This is because when you take a spread position, you are essentially hedging your exposure.

• Lower cost. Spread trading often has lower commissions and fees than traditional trades, making it an attractive option for those on a budget.

• High leverage. Often, spread trading offers high leverage, which can amplify potential profits, as well as potential losses.

• Increased market efficiency. Choosing spread trading could potentially help to increase market efficiency by providing a more liquid market and better price discovery.

• Lower volatility. Spread trading generally tends to be less volatile than traditional trades which can help to reduce risk.

Popular spread trading strategies

There are a number of spread trading strategies favoured by traders, some of these include:

1. Momentum trading. This strategy involves taking a position in a security that is exhibiting strong price momentum. This can be done by buying the security when it is trending higher and selling it when it begins to pull back.

2. Pair trading. This involves taking a long position in one security and a short position in another, related to the first. This can be done when two securities are exhibiting divergent movements, such as one going up and the other down.

3. Arbitrage trading. This involves taking advantage of price discrepancies between two or more markets. This is done by buying the asset in one market and simultaneously selling it in another market for a higher price.

4. Reversal trading. This strategy involves taking a position in the opposite direction of the current trend. This can be done by buying the security when it is trending lower and selling it when it begins to rise.

5. Trend trading. This strategy involves taking a position in the direction of the current trend. This can be done by buying the security when it is trending higher and selling it when it begins to pull back.

Spread risks

Spread risk is the risk that arises from the possibility that the spread between two different investments or asset classes will move against an investor’s expectations. 

When the spread between two investments moves against an investor’s expectations, it can result in a loss. Some of the common spread risks include basis risk, yield curve risk, liquidity risk, counterparty risk and currency risk. 

Other spread risks include:

• Market risk. This is the risk of an investment’s value changing due to the overall fluctuations in the market. This type of risk is linked to macroeconomic factors and cannot be diversified away.

• Interest rate risk. This is the possibility that the value of an investment will decrease due to changing interest rates. This type of risk is typically associated with fixed-income securities such as bonds.

• Currency risk. Currency risk is the possibility of an investment’s value changing due to fluctuations in the exchange rate between two currencies. This type of risk is particularly relevant for investments in international markets.

• Political risk. Political risk is the risk that a government policy or event could negatively affect the value of an investment. This type of risk is particularly relevant for investments in emerging markets.

• Liquidity risk. Liquidity risk is the risk that an investment cannot be sold quickly enough to prevent a loss. This type of risk is particularly relevant for investments in illiquid markets.

Conclusion

Spreads are an important part of trading, as well as day-to-day finance, understanding spreads could go a long way to helping traders make well-informed trading decisions. 

Traders should be sure to do their own research before making any trading decisions, taking into account their expertise in the market, attitude towards risk and the spread of their portfolio amongst other factors. They should also be sure to never invest more money than they can afford to lose.

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