What is a spread?
A spread can have several meanings in finance. Generally, the spread refers to the difference or gap between two prices, rates, or yields.
One of the most often used definitions of a spread is the difference between the asking and bid prices of an item or security, such as a commodity, stock, or bond. We refer to this as a bid-ask spread. In the financial markets, spreads may be created, among other things, between two or more contracts for derivatives, equities, or bonds.
Understanding Spreads
In trading terms, spreads may also mean the difference between a short position, selling in one futures contract or currency, and an extended position, purchasing in another. Officially, this is referred to as a spread trade.
The spread in underwriting refers to the difference between the price an investor pays for a security and the amount paid to the security’s issuer; in other words, the price an underwriter must pay to purchase an issue as opposed to the price at which the underwriter sells it to the general public.
The amount a borrower must pay over a benchmark yield to get a loan is often called the spread in lending. For instance, if a borrower obtains a mortgage with a 5% interest rate and the prime interest rate is 3%, the spread is 2%.
Another name for the spread trade is the relative value trade. Buying one security and selling another linked security as a unit is a spread transaction. Spread trades are often executed using futures or options contracts. These deals result from the spread, a positive total net transaction value.
Spreads are often quoted as a single unit or as pairs on derivatives markets to facilitate the simultaneous purchase and sale of securities. Doing this eliminates the possibility of one pair of components executing while the other fails.
Spread Types
Many financial markets include spreads, which change based on the kind of financial instrument or asset being traded.
The gap between the highest bid price and the lowest offer is known as the bid-ask spread, and it is present in many assets with a two-sided market, such as most stocks. One standard metric for assessing a stock’s liquidity is the bid-ask spread.
In forex trading, bid-ask spreads are also typical. They may change based on market circumstances, the broker’s pricing policy, and the currency pair’s liquidity. While some brokers only charge fixed spreads, others charge variable spreads that change according to the state of the market. Spreads may have a significant influence on the total cost of a deal. Therefore, traders must understand what they are being charged.
Unlimited Techniques
A trader may employ a spread strategy to benefit from a bullish, bearish, sideways, or narrowing spread, among other situations, since spreads can be formed in various ways. As a result, traders use spreading as a highly versatile strategy.
Spreads in Interest Rates
A yield spread is a difference, determined by subtracting the yield of one instrument from the other, between the yields on different debt instruments with different maturities, credit ratings, issuers, or levels of risk. The most common ways to describe this difference are basis points (bps) or percentage points. Often expressed as a single yield compared to the yield on U.S. Treasury bonds, yield spreads are also known as credit spreads. The “yield spread of X over Y” is how some analysts refer to the yield spread. The annual percentage return on investment of one financial instrument, less the annual percentage return on investment of another, is typically what this represents.
The option-adjusted spread (OAS) measures the difference in yield between Treasury bonds and bonds with an embedded option, such as an MBS. Compared to comparing a bond’s yield to maturity to a benchmark, it is more accurate. Analysts may independently ascertain if the investment is profitable at a specific price by examining the embedded option and bond security. The yield spread has to be applied to a benchmark yield curve to discount a security’s price and align it with the current market price. An option-adjusted spread is a name given to this modified pricing. Typically, this is used for bonds, interest-rate derivatives, mortgage-backed securities (MBS), and options. In the case of assets with cash flows independent of future changes in interest rates, the Z-spread and the option-adjusted spread coincide.
The Z-spread is the constant difference between the yield and the security price at each point on the spot rate Treasury curve where cash flow is received. It raises the price of a security to the present value of its cash flows. It may provide the investor with the bond’s cash flows and current value at these moments. Investors and analysts use the spread to identify price disparities in bonds. The zero-volatility and yield curve spreads are other names for the Z-spread. The Z-spread backs mortgage-backed securities. The spread that emerges from zero-coupon Treasury yield curves is required to obtain the current market price by discounting a pre-established cash flow plan. The credit spread is also measured using this spread in credit default swaps (CDS).
Example of Interest Rate Spread
Let’s say an investor is debating between a 3%-yielding U.S. Treasury bond and a 5%-yielding corporate bond from Company XYZ. In this instance, the yield spread would be 2% (5%–3%), meaning that the yield on the corporate bond is 2% higher than that on the U.S. Treasury bond.
An investor may purchase the corporate bond and sell the U.S. Treasury bond to capitalize on the yield spread if they think there is little chance of default on the corporate bond and the firm is solvent. We’d call this a “yield spread trade.”
Investors will get the 5% return on the corporate bond and benefit from the 2% yield spread if their assessment of Company XYZ’s credit risk is accurate and the bond performs as predicted. However, the investor can lose their whole bond investment if Company XYZ’s credit risk turns out to be bigger than anticipated and the bond fails. Because of this, before making a yield spread trade, investors should thoroughly assess the credit risk associated with each bond.
Spreads for Options
Many calls are bought and sold concurrently on the same underlying call spread. When the underlying rises, a bull call spread makes money; when the underlying falls, a bear call spread makes money.
Put spreads are similar to calls, except they use put options instead. There are bull and bear put spreads, much like call spreads.
The simultaneous purchase of two options with lower strike prices, the simultaneous selling of one option with a higher strike price, and the simultaneous sale of another option with an even higher strike price constitute a long butterfly strategy, which leans neutral to bullish. The aim is to make money from a small range of fluctuations in the underlying asset. The condor and iron butterfly are some of the variations of the butterfly.
Calendar spreads are a technique whereby an option with a longer-term expiry date is simultaneously purchased on the same underlying asset as a shorter-term option and vice versa. The objective is to make money by exploiting discrepancies between the two option decay rates.
Purchasing a bear put spread in addition to a bull call spread is known as a “long box,” or box spread, in the context of options arbitrage. As two vertical spreads with identical strike prices and expiry dates, a box spread is always worth the difference between the strike prices at expiration.
Example of an Options Spread
A bull call spread is an example of a spread utilized in trading. Buying a call option with a strike price below the current market price and simultaneously selling another call option at a higher strike price constitute this bullish options trading technique.
For example, suppose that the current price of XYZ stock is $50 per share. If an investor is optimistic about XYZ stock, they may purchase a call option with a $45 strike price and sell a call option with a $55 strike price. This bull call spread aims to minimize the possible loss if the XYZ stock price moves against expectations while profiting from an upward surge in the company’s price.
The call option with a $45 strike price per share would be in the money and have a value of $15 per share ($60 market price minus $45 strike price) if the price of XYZ stock increases to $60 per share. Although it would only have a $5 per share value ($60 market price minus $55 strike price), the call option with a $55 strike price would also be in the money. The difference between the two possibilities, or $10 per share, would represent the investor’s net profit.
Both options would expire worthless, and the investor would forfeit the premium paid for the call option acquired if the price of XYZ stock does not climb over the strike price of the call option sold, which, in this example, is $55 per share. For this reason, the bull call spread is seen as a technique with little risk.
Distribute Dangers
Like any other kind of trading, spread trading has a variety of hazards that investors and traders need to be aware of. For instance, market risk may impact the spread trade’s profitability and the value of the underlying assets. Thus, a trader may lose money on a spread trade if they buy a bull call spread on a company they think will increase in price, but the stock suddenly declines owing to market circumstances. Similarly, you may lose money if you wager that a spread will contract, but it will widen.
Spreads may also have the following additional risks:
- The risk associated with liquidity may make it more challenging to acquire or sell assets when required, leading to larger spreads and higher trading expenses.
- Since the danger of default or credit events may result in significant losses, credit risk should be considered when spread trading with leverage or with securities with lower credit ratings.
- Volatility risk may impact the profitability of a spread transaction because it may make it more challenging to predict the size and direction of price fluctuations.
- Since spread transactions may use derivatives or other financial instruments that depend on a counterparty’s creditworthiness, counterparty risk may also be problematic. The trader or investor may suffer significant losses if the counterparty defaults on its commitments.
How is a spread in finance calculated?
The difference between two prices determines a spread. The offer price minus the bid price is how one calculates a bid-ask spread. The pricing of an option spread is calculated as follows: one option’s price minus the other’s.
What Makes a Person Purchase a Spread?
By making the wager that the spread’s magnitude will eventually contract or expand, traders attempt to make money off of spreads. Purchasing a spread indicates your belief that the difference between the two prices will increase. For instance, you may purchase that yield spread if trash bond interest rates increase faster than Treasury rates.
In trading, how do you put on a spread?
To take a spread position in the markets, you typically purchase one security or asset and sell a related one simultaneously. The difference between the amount paid and the selling revenues is the resultant spread price.
The Final Word
The difference or gap between two prices, rates, or yields is a spread in the financial world. The bid-ask spread, or the difference between the asking and bid prices of an asset or security, is one way the term “spread” is often used. The term “spread” may also refer to the difference in a trading position, e.g., the difference between a spread trade, which is the selling position in one futures contract or currency, and the purchasing position in another. Spreads may also relate to the price a borrower pays above a benchmark yield in lending or the difference between the amount paid to the security’s issuer and the price the investor paid for it during underwriting. Spreads come in various forms and are used in many financial situations. These include yield spreads, option-adjusted spreads, and Z-spreads.
Conclusion
- The difference between two prices, rates, or yields is a spread in the financial world.
- The bid-ask spread, which describes the difference between the asking and bid prices of an asset or security, is among the most popular.
- A spread may also be the difference in trading between an extended position (buying) in one currency or futures contract and a short one (selling) in another.
