Spread (Trading) - Explained
What is a Spread?
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Table of ContentsWhat is a Spread in Trading? How Does the Bid-Ask Spread Work?Spread TradeYield SpreadOption-Adjusted SpreadZ-Spread
What is a Spread in Trading?
A spread is an important term in finance, foreign exchange market, investment market and buying and selling of commodities. A spread refers to the difference in the prices quoted for the sale and purchase of a commodity, stock, currency, and bonds. It also describes the difference in the return rates or yields of investment instruments. A spread is also the difference in the amount an investor pays for security and the amount paid to the issuer. Spread, as it appears in bid-ask spread refers to the difference or gap between the bid price and ask price of security or investment instrument. When an investor takes a position in the investment market, a spread is used to describe a gap between a short-term position in investment and a long-term position in another.
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How Does the Bid-Ask Spread Work?
A bid-ask spread is described as a gap between the selling price of an asset or commodity and the amount paid by the buyer. In the trade of goods, commodities, and securities, prices are quoted by both the sellers and the buyers. The bid price refers to the maximum price a buyer is willing to pay to a commodity while the ask/asking price is the price a seller is willing to accept for the purchase of a commodity, which can either be fixed or negotiable. The difference between an asking price and a bid price is known as the bid-ask spread. Factors that affect bid-ask spread are;
- The trading activity for a day,
- The number of shares or stocks available for the trade which is called supply or float, and
- The number of shares demanded by traders for the trading day.
A spread trade often occurs in futures contracts when an investor simultaneously buys two related and bundled securities as single units. It also occurs when there is a gap resulting from the combination of a long position and a short position in options or futures contracts, these positions are called legs. A spread trade is otherwise called the relative trade value trade.
Yield spread indicates the difference in the credit qualities of two different investment instruments that have similar maturity periods. Oftentimes, different investments have different rates of returns otherwise called yield. The yield spread shows how the quoted return on investment for two investment instruments differ from each other. The credit spread is another term for the yield spread. Since the quoted rate of return on investment is influenced by the amount of risk in the investment. The difference between the yields of two investment vehicles (yield spread) shows the amount of risk in the underlying investment.
The option-adjusted spread is a type of gap or difference realized when the price of a security is discounted and matched to the present market price with the aim of getting an adjusted price. This means the benchmark yield or the benchmark yield curve will be added to the yield spread to get the adjusted price. The important points you should know about spread include the following;
- Spread refers to the gap between rates and yields, it is also the difference between two prices such at asking price and bid price.
- Bid-ask spread is a common type of spread which describes the difference between the bid price (the highest amount buyers are willing to pay for a product) and the ask price (the lowest amount sellers are willing to sell a product).
- Yield spread, spread trade and option-adjusted spread are other forms of spread that exist.
- When an investor takes both a long and short position on similar options or contracts, a spread can occur.
Z spread refers to a zero-volatility spread otherwise referred to as yield curve spread. Z SPRD is common in mortgage-backed securities and credit default swaps (CDS). when there is a zero-coupon Treasury yield curve or a shift in the spread which is necessary for discounting the price of a security to reach the current market value, Z SPRD will occur.