Spread

Spread is the price, interest rate, or yield differentials of stocks, bonds, futures contracts, options, and currency pairs of related quantities. It also represents the lowest price movement that a foreign exchange rate can make per market standards.

A spread varies based on the type of trading and the asset traded and is commonly expressed in pips. It is usually profit for the broker who initiates and manages the asset purchase and sale on behalf of the investor. It can be small or large, depending on how much the bid (from buyers) and ask (from sellers) prices diverge.

• Spreads is the variation in prices, interest rates, or returns of stocks, bonds, futures contracts, options, and currency pairs of related quantities.
• It is usually represented in pips and varies with the type of trading and the asset or security traded. It can be modest or enormous, depending on the gap between the ask and prices.
• A Forex spread signifies the variation between the ask and bid price of a currency pair, such as EUR/USD, GBP/USD, or USD/JPY. It may be either fixed or variable.
• The common types of spreads are bid-ask, yield, option-adjusted, zero-volatility, and credit. Spreads trading involves buying one security and selling a different one with similar attributes as a unit.

Spreads have multiple meanings, depending on the context. For example –

• Finance - It is a difference between prices, interest rates, or returns of assets of related quantities.
• Stock Trading - It depicts the difference between ask price and bid price for a specific asset.
• Futures Trading - It defines the gap in the price of a similar commodity between delivery months.
• Bonds Trading - It describes the variation in yields between identical bonds of varying maturities.
• Lending - It denotes the amount a borrower pays above a benchmark yield to obtain a loan.
• Stock Option - Stock Option shows the variation between the strike price and the market value.
• Underwriting - The gap between the prices an underwriter purchases a security from the issuer and sells the same to the general public.
• Investing - It is the gap between the short-term and the long-term positions in related investments. The returns for an investor depend entirely on the price difference at which they buy or sell a financial product.

Brokers or market makers never charge a fee or take a commission for initiating and performing trades on behalf of traders. Instead, they offer two prices – bid and ask or offer. In this case, the asset's bid price should always be greater than the underlying market, while the asking price should always be lower. The difference between, i.e., spread, becomes the broker’s profit. This strategy allows brokers to make more and more profits during a slow market.

It is worth noting that traders must pay a commission to brokers when trading shares, while some assets may demand both a fee and a commission.

Spreads Trades

Spreads trading is about an investor purchasing security and then selling another with similar characteristics like a unit simultaneously. The relative value trading is more frequent in options, futures contracts, or currencies, where each transaction is termed a leg.

The difference between a short (selling) and a long (buying) position results in a total net holding (spread) that fluctuates depending on the price difference between the legs. Overall, it allows investors to benefit by exploiting market inequities. There are three types of trade that fall within this category:

1. Calendar Spread Trading: It involves buying or selling a security or asset based on its projected prices for different dates. Futures with specific delivery months are an example of it.
2. Inter-Commodity Spread Trading: It marks the economic connection between two contrasting but related commodities. The interrelation between oil and its by-products or the price difference between precious metals like gold and silver are ideal examples.
3. Spreads Options Trading: Refers to purchasing and selling different options contracts for the same underlying asset or security with varied strike prices and expiration dates. It then determines the variation in the yields.

Let us consider the following spreads examples to understand the concept better:

Example #1

Maria applied for a home loan at the ABC Bank. The bank approved the loan at a rate of 6%, whereas the prime interest rate is 4%. In the context of lending, the spread is 2%, i.e., the variation between the interest rates a bank charges a borrower and pays a depositor.

Example #2

Spreads trading of futures contracts is the variation in prices for the same commodity at multiple delivery dates. The significant fluctuation in wheat prices in the futures market occurs from January to October. Traders can calculate the futures contract spreads in this scenario by subtracting the wheat price in January from the rate in October. Given the delivery months, market swings predict a narrowing and widening of spreads in the wheat market.

Spreads are of various types based on the trading markets:

#1 - Bid-Ask Spread

It is the gap between the bid or buy price and ask or sell price for stocks, bonds, options, futures contracts, or currencies. Traders can use it to determine the market's liquidity, volume, and volatility.

#2 - Yield Spread

It signifies the yield difference between two debt securities (e.g., bonds) with differing maturities, risks, and credit ratings. Investors can use it to compare different investment products before deciding where to invest.

#3 - Option-Adjusted Spread

It denotes the price difference between an asset or security with a condition or option embedded in it and the same financial instrument without such an option. This condition or option associated with the asset or security affects its redemption. In short, it allows traders to assess bonds, options contracts, and mortgage-backed securities (MBS) without the condition and determine whether investing in them at the current price is fair.

#4 - Z-Spread

The zero-volatility or yield curve spread finds significance in MBS and credit default swaps. It occurs when the difference narrows to the point where the cost of an asset or security equals the existing value of its cash flows. Or it results due to a change in the yield curve of the zero-coupon Treasury.

This situation calls for depreciating pre-determined cash flows to help the asset or security achieve its existing market price. Traders can use it to spot price differences in bonds.

#5 - Credit Spread

It marks the variation in yields between debt security and a US Treasury Bond with a similar maturity period. It also indicates an options strategy for an underlying asset where a trader buys a premium option at a lower price and then sells it at a higher rate.

In the foreign exchange (Forex) market, a spread is the gap between the bid and ask prices of a currency pair, such as EUR/USD, GBP/USD, or USD/JPY. It can either be fixed or variable. Brokers profit from the spread applied that varies with the currency pair, volume, and market volatility. A wider gap means high volatility and low liquidity, and vice versa.

For instance, Paola wants to buy a currency pair of the euro and the US dollar. The bid (buy) price of the EUR/USD displayed on the Forex chart is 1.6366. However, the asking price at which the broker wants to sell it is 1.6369. So, the spread here will be 0.0003 (i.e., 1.6369-1.6366). It is, however, read as 3 pips based on the last or fourth decimal point on the price quote. Thus, it is possible to say that EUR/USD trades with a 3-pip spread.

Though the steps for calculation are the same, spreads for different currency pairs vary. There is a mid-price too in Forex. It results from dividing the sum of the bid and ask prices by 2. However, this mid-value of the two prices is not used that often in trading, but it serves to be useful when the market is too volatile.

Let us look at the following Euro/US Dollar chart to better understand the concept of bid-ask spread. 

Source

As one can observe from the above chart, the red line represents the ask price. On the other hand, the green line denotes the bid price. The difference between the two is the spread. In the chart, the blue portion between the bid and ask prices demonstrates the spread. Note that the bid price and ask price are almost never equal. Thus, spread almost always exists. That said, the spread’s size may vary depending on the market’s liquidity. 

Typically, the higher the liquidity, the lower the spread because of the large number of market participants and high trading volume. That said, in markets with low liquidity, the spreads are mostly high because of low trading volumes resulting from a very small number of market participants engaging in the buying and selling of the asset.

In the case of this chart, the bid and ask prices are 1.0249 and 1.0269, respectively. Therefore, the spread will be 0.002 (1.0269-1.0249). 

If an individual wishes to enhance their knowledge concerning this particular concept, they can consider taking a look at such charts that are already published on the online platform of TradingView. 

This has been a guide to spreads and their meaning. Here we discuss how do spreads works, along with examples, types, and Forex. You may also learn more from the following articles -