What is the spread in trading?
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The term ‘spread’ can have several meanings in investing and financial services, but it generally refers to the difference between two prices, rates or yields. One example would be the bid-ask spread, where the spread is concerned with two primary factors: what traders are willing to pay when buying an asset, security or commodity; and the price that the market is prepared to sell it at. However, spread has a slightly different meaning in bond markets and it is best to look at a few examples.
Here we consider some of the more common spreads that an investor may encounter:
The bid-ask spread, sometimes called the bid-offer spread or buy-sell spread, refers to the difference between the prices that were quoted 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 $15 and the bid price for the same stock is $13.50, then the bid-ask spread for that stock is $1.50. The size of the bid-ask spread in a security is also a good measure of a market’s liquidity. For example, the currency market is generally considered to be the most liquid in the financial world, with a bid-ask spread often as small as 0.001%.
The yield spread, also called the credit spread, refers to the difference between the rates of return for two different investments, as quoted in an order book or by a market maker. It is often used as an indicator of risk for one investment product compared to another. With bonds, the yield spread refers to the difference in the yield on two different bonds or two classes of bonds. Investors use the spread as an indication of the relative pricing or valuation of a bond. If one bond yields 3% and another yields 1%, the yield spread is 2% or 200 basis points. This is useful for the investor to know as the bond or class of bond with the higher yield is considered riskier, with the higher yield being compensation for this risk differential.
An option-adjusted spread (OAS) is similar to a yield spread but is used for bonds with embedded options or features that allow the bond issuer or holder to take a particular action in the future. The option-adjusted spread represents the spread after adjusting for, or removing, the bond’s option.
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). Therefore, the OAS of a security is dependent on the assumptions made (eg. variable interest rates) and can be interpreted as its "expected outperformance" versus the benchmarks, if the cash flows and the yield curve behave consistently with the valuation model.
As with the OAS, the Z-spread or zero-volatility spread is used to calculate the current or future value of a security. This is generally used to provide analysts with a way to evaluate a bond's pricing as it maps the difference between the present cash flow value and the U.S. Treasury spot rate yield curve.
Like the OAS, the Z-spread can be a measure that assists investors in comparing the yield of two different fixed-income offerings that have embedded options. Embedded options are provisions included with some fixed-income securities that allow the investor or the issuer to do specific actions, such as calling back the issue. For example, mortgage-backed securities often have embedded options due to the prepayment risk associated with the underlying mortgages.
There are three main factors that contribute to the differences between spreads:
As with the bid-ask spread example, a security's liquidity is vital to the various spread models. Liquidity here refers to the volume or number of shares traded on a daily basis. Some assets are traded regularly while others are only traded a few times a day.
The stocks and indexes that have large trading volumes will have narrower bid-ask spreads than those that are infrequently traded. When a stock has a low trading volume, it is considered illiquid because it is not easily converted to cash. As a result, a broker will require more compensation for handling the transaction, accounting for the larger spread.
Volatility is another important aspect when considering spreads. For example, the bid-ask spread is much wider during periods of rapid market rises or falls as market makers attempt to take advantage of the opportunities this provides. Likewise, when volatility is low, and uncertainty and risk are at a minimum, the bid-ask spread is narrow.
A market maker can take advantage of a bid-ask spread simply by buying and selling an asset simultaneously. By selling at the higher ask price and buying at the lower bid price over and over, market makers can take the spread as arbitrage profit. Even a small spread can provide significant profits if traded in a large quantity all day. As previously mentioned, assets in high demand have smaller spreads as market makers compete and narrow the spread.
If markets are functionally normal then the bid-ask spread can’t be negative. The amount by which the ask price exceeds the bid is essentially the difference in price between the highest price that a buyer is willing to pay for an asset and the lowest price for which a seller is willing to sell it. Therefore, if an investor is willing to sell a stock for $12 and another is willing to buy it for $10 then no trade happens until someone crosses the spread. There is no bid or ask until someone else comes along.
There are a number of different ways to define ‘spread’ in trading, although it typically refers to the difference between two numbers such as prices, rates or yields. Spread is also relevant to a variety of asset classes, such as stocks, options, futures and currencies. Generally however, when referring to ‘trading the spread’, traders are referencing the bid-ask spread. As mentioned above, repeatedly selling assets at a higher ask price and buying at a lower bid price is how traders profit, and while it’s preferable to have a wide bid-ask spread, even trading a small spread can be profitable depending on the quantity of trades.
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