Last Updated on Feb 10, 2022 by Ayushi Mishra
When you trade in stocks, bonds, currencies and other market-linked securities, you would come across the word ‘spread’. It is a very common term in the financial world and is imperative for you to understand it to make the right trading decisions. Let’s find out what spread is all about in the world of financial trading and the factors that affect it.
This article covers:
- What is spread?
- The concept of spread in different types of trades
- Factors affecting spread
- The concept of the bid-offer spread
- Spread trades
- Other types of spreads
Table of Contents
What is spread?
In the simplest of definitions, the spread is defined as the difference between two prices of the same asset. These two prices are the bid price (purchase price) and the asking price (sale price). However, in some cases, the spread can also denote the difference between two values that are related to one another.
In general, the spread is the difference between the bid price (purchase price) and the asking price (sale price) of the same asset. Click To Tweet
The concept of spread in different types of trade
The trading world consists of different types of securities and the spread for each type of security is calculated differently. Have a look.
Stocks
In the case of stocks, the spread is the difference between the bid price and the asking price. It is also called the bid-ask spread. It is the difference between the highest price that the buyer is willing to pay for a stock (denoting the bid price) and the lowest price at which the seller is willing to sell the stock (referring to the asking price).
Currencies
Even in the case of currency trading, the spread is the difference between the bid and ask prices. It denotes the cost of trading for traders and the profit that the dealers can earn.
Futures
In a futures contract, the delivery dates of different contracts of the same asset are, usually, different. So, spread in a futures contract is the difference in the price of the asset on different delivery dates. For example, in two futures contracts of wheat, the price of wheat would be different on different delivery dates. This difference would be the spread.
Bonds
Spreads in bonds work differently. They are calculated as the difference between the yield of two different bonds, both of which have the same maturity tenure. For example, if a bond with 6% interest and one yielding 8% have the same maturity period of 1 yr, the spread between these bonds would be 2%.
Factors affecting spread
There are three primary factors that affect the spread between two values.
- Liquidity: If an asset can be easily converted to cash, it is said to be liquid. The more liquid the asset, the lower would be the spread and vice-versa.
- Volatility: If the markets are highly volatile, the spread could be higher and vice-versa.
- Trading volume: Assets that are traded in large volumes tend to have a low spread. For instance, in the case of stocks or currencies, the spreads are marginal compared to bonds or other assets with limited trading volumes.
The concept of the bid-offer spread
Bid-offer or bid-ask spread is the most common type of spread that is overheard frequently in the trading world. It means the difference between the prices quoted by a market maker for immediate purchase and sale of the asset. The asset can be currencies, stocks, futures, or options.
The value of the bid-offer spread helps investors and traders gauge the liquidity of the asset. If the spread is large, the asset is said to be less liquid and vice-versa.
Spread trades
Also called Relative Value Trades, spread trades occur when investors buy and sell two related securities, bundled as a single unit, simultaneously. Every transaction is called a ‘leg’ and spread trades can have multiple ‘legs’. For example, if investors buy and sell futures and options simultaneously, as a bundle, they are said to be engaging in a spread trade.
The objective behind a spread trade is to earn a profit from the difference in spreads between the two trades. Due to market imbalances, traders can enjoy the potential of earning returns through spread trades. Moreover, such trades also help you hedge against market volatilities.
Spread trades can be of three types. These are as follows.
Calendar spreads
In this trade, the price of the asset at different dates or months is considered. The trade is done based on the expected performance of the asset on a given date based on the price of the asset at a past calendar date. For example, expecting to earn a profit from the increase in the price of a stock after 3 mth.
Option spreads
Under option spreads, you buy and sell the same stock but in each contract the strike price is different.
Inter-commodity spreads
Under this type of trade, you trade in commodities that have interdependent prices. For example, gold and silver prices are interconnected. So, when you opt for spread trading in these commodities, it is called inter-commodity spreads.
Other types of spreads
Here are some other types of spreads that you should know about.
Yield spread
The difference between the rate of return on two different investments, as quoted by a market-maker, is called a yield or credit spread. The concept of the yield spread is used to denote the difference between the yield to maturity of two investments.
Option-adjusted spread
This type of spread is used in the case of mortgage-backed securities, options, interest rate derivatives, and bonds. This type of spread is calculated by adding the yield spread and the benchmark yield curve.
Z-spread
The spread that you get from using a zero-coupon Treasury yield curve is called the Z-spread or the yield curve spread.
Credit spread
The difference between a debt instrument and a government bond is called the credit spread. However, to calculate the credit spread, both the assets should have the same maturity tenure.
The concept of spread is used extensively in the financial trading world. So, understand what the concept is all about and how it works when trading in stocks, derivatives or bonds. Use spreads to your advantage so that you can make a profit on your trades.
The concept of spread is used extensively in the financial trading world. So, understand what the concept is all about and how it works when trading in stocks, derivatives or bonds. Use spreads to your advantage so that you can make a profit on your trades.
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