Spread is a term that’s used often in the stock market and other financial markets. Although the term is important, it can be difficult for investors to understand because there are multiple types of spreads, each with a different purpose.
But what exactly is a spread and how does understanding this term equate to better investment outcomes?
What Is a Spread in Finance?
The term spread is used in finance to describe the difference between two prices, interest rates, or yields. For example, the spread between $10 and $10.50 is $0.50.
Even if you’ve never invested a penny in the past, chances are you’ve paid a spread in your lifetime. If you have a loan with an interest rate, the difference between the rate you pay and the prime rate set by the United States Federal Reserve is known as a bank spread.
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In the stock market, the term most commonly refers to a bid/ask spread, or the difference between the price buyers are willing to pay for a stock (the bid) and the price sellers are willing to accept for a stock (the ask).
Spread can also refer to the difference in yields on bonds and other debt securities, or it can be used to compare any other two numeric values.
How Investment Spread Works
When investors mention a spread, they’re most commonly referring to the bid/ask spread — the difference between the bid price and the asking price of a stock, exchange-traded fund (ETF), forex currency pair, or other financial instrument.
For example, say an investor is willing to sell five shares of ABC stock for $10 each. On the other side of the trade, a buyer has entered an order to buy ABC stock at $9.99 per share. In this case, the spread is $0.01.
There are three main factors that determine the spread:
- Public Float. The public float is the number of shares of a stock that are available and tradable on the open market. Low-float stocks, or stocks with fewer shares available, are known for limited demand and large spreads. On the other hand, high-float stocks tend to have smaller spreads.
- Public Interest. The law of supply and demand dictates market prices and also plays into spreads. Stocks with big public followings experience high demand, resulting in low spreads. Lesser-known stocks are met with less demand, resulting in larger spreads.
- Trading Volume. Stocks with higher trading volume are known for smaller spreads than stocks with lower trading volumes.
Types of Spread
There are several different spreads in finance, but in the world of investing, four types of spreads are commonly used:
Bid-Ask Spread
The bid price on a financial instrument is the highest price a buyer is willing to pay for it, while the ask price is the lowest price a seller is willing to accept for it. The difference between the two prices is the bid/ask spread.
The more narrow the spread between the bid and ask prices, the more in-demand the financial asset is. Of course, that means when there are wider spreads, the demand for the financial asset is minimal.
Typically, investors prefer a narrow spread on stocks. Not only does a narrow spread suggest higher demand and liquidity, it also results in a lower cost to the investor when placing some types of orders.
When you place a market order, it is executed immediately at the current market price and the spread is paid to the market maker, typically the brokerage. When you place a limit order, execution will wait until the market price reaches the limit price, reducing the cost of the trade. This is why many investors prefer limit orders to market orders.
Yield Spread
A yield spread is the difference in yields between two bonds.
Yield spreads are calculated by subtracting one yield from another and are displayed as a percentage or in basis points. For example, imagine a 10-year corporate bond produces a 4.1% yield while a 10-year Treasury bond produces a 2.93%. The yield spread between the two is 1.17% or 117 basis points.
In most cases, yield spreads compare a bond’s yield to Treasury yields. That specific comparison is known as the credit spread. That means all credit spreads are yield spreads, not all yield spreads are credit spreads.
Option-Adjusted Spread (OAS)
Option-adjusted spreads are used to compare yields between Treasury bonds and bonds with embedded options. There are several options that can be embedded in bonds, each changing the investment’s risk and return. Some of the most common include:
- Callable. Callable bonds give the bond issuer the ability to redeem the bond before its maturity date under certain conditions.
- Putable. Putable bonds give the investor the ability to sell the bond back to the issuer prior to the maturity date under certain conditions.
- Convertible. Convertible bondholders can convert the bond into a specific number of shares of the issuer’s common stock or cash of equal value.
- Extendible. Extendible bonds give investors the right to extend the maturity date of the bond for a predetermined number of years.
- Exchangeable. Exchangeable bonds give the investor the ability to exchange the bond for a certain number of shares of a specified company other than the issuer of the bond.
Each of these options come with their own set of potential risks and rewards. This makes comparing them to benchmarks like Treasury bond yields less straightforward.
Analysts adjust bond yields based on these embedded options to account for the change in risk and return they represent.
Zero-Volatility Spread (Z-Spread)
The zero-volatility spread, also commonly known as the Z-spread or the static spread, is a tool that tells you the current value of a bond plus its cash flows on points of the Treasury yield curve when the cash is received. This means the Z-spread measures the yield you will receive in comparison to the yield curve over the entire length of the bond.
Analysts use complex equations to calculate the Z-spread to determine if there are any discrepancies in the price of a security. The bond is undervalued when it’s priced lower than the Z-spread and overvalued when it’s priced higher.
What the Spread Tells You
Each type of spread tells you something different. Some relate to the liquidity of an asset and others relate to the returns or valuation of an investment. Here’s what you learn from each different type of investment spread:
Bid/Ask Spread Suggests Liquidity
The bid/ask spread is a measure of liquidity in financial markets. Stocks, ETFs, and other assets that experience high levels of liquidity will trade with low bid/ask spreads, while those with lower levels of liquidity will trade with high spreads.
A low bid/ask spread is more appealing than a high one. Low spreads also reduce the cost of market orders when investors pay the spread in order to have their orders executed immediately.
Yield Spread Indicates Returns
The yield spread tells you about the returns you can expect when making fixed-income investments. A high yield spread tells you you’re receiving favorable returns when comparing your bond to a benchmark like the prime rate. A narrow yield spread tells you your returns are in line with market averages, while a negative yield spread tells you your money is better used elsewhere.
Option-Adjusted Spread (OAS) Helps Compare Complex Bond Yields
Option-adjusted spreads help to compare yields on more complex bonds with embedded options to simple Treasury bond yields. Some believe the OAS gives a more accurate measure of yield spreads on these types of assets, while others believe the use of historical data in future predictions produces inaccurate results.
Z-Spread Helps Value Bonds
Many believe the Z-spread to be the most accurate way to measure whether a bond is undervalued or overvalued because it compares bond yields to the Treasury yield curve over the life of the bond. Comparing the Z-spread to the bond’s price tells you if you’re underpaying, overpaying, or paying a fair market price when you buy the bond.
Investment Spread FAQs
If you’re like most people, you’ve got a question or two about investment spreads. Some of the most common questions about these metrics are answered below:
How Can You Use Spread in Your Trading Strategy?
The bid/ask spread is an important consideration whether you’re trading stocks, ETFs, or currency pairs. Trading is a fast-paced process that requires liquidity. So, it’s best to trade assets with narrow spreads that tell you there are high levels of liquidity.
Also, the bid/ask spread becomes more important when you take part in high-volume trading strategies like scalping. You should only trade narrow-spread assets to keep your costs low!
What Is Spread Trading?
Spread trading, also known as relative value trading, is a trading strategy that requires the simultaneous purchase and sale of related assets, most commonly options and futures contracts.
One example is known as the calendar spread, or time spread, which requires the purchase of two similar options with different maturities. If the short-term option decays faster than the long-term option, the spread between the two widens and the trade is closed for a profit.
What Is a Bank Spread
A bank spread is the premium lenders add when charging interest on loans. For example, if you have a credit card with a variable interest rate priced at “prime plus 10%,” you pay whatever the prime rate is at the time plus a bank spread of 10%.
Final Word
It’s important to pay close attention to spreads whether you’re investing in stocks, funds, forex, bonds, or any other asset. These metrics tell you how easily you’ll be able to exit an investment, whether you’re likely to generate a reasonable return on fixed-income investments, or whether the bonds you’re purchasing are priced fairly.
Spreads also point to the price you’ll pay to execute orders immediately in the stock market and to execute orders at all in foreign exchange markets.
If a focus on spreads hasn’t been involved in your investment research in the past, now’s the time to add it.
