While the term spread holds an array of meanings in finance, all tie back to the difference of two measurements, typically in reference to price, rates or yields. Spreads are an essential component to trading because it determines the price of underlying securities.
In this article we will define each version of a spread and how to incorporate spreads in trading strategies.
How Does a Spread Work?
So how do spreads work? Spreads are profits that are then taken by the broker. For the investor, the tighter the spread the better since this means the cost is smaller. Those who have wider or larger spreads are trading with more commission cost.
What Is a Spread Trade?
Spread trades, also referred to as relative value trades, are the acts of purchasing a security and then selling a different security.
Investors use spread trades to hedge against volatility and declines in asset value. This allows investors to hold on to their shares as they determine the amount of risk they want to involve themselves in.
What Is a Yield Spread?
Yield spreads, sometimes referred to as credit spreads, are the difference between the bond yield and the risk-free rate. Yields are used to determine what investments are best to look into.
Typically the higher the yield spread, the more risk the investor takes on. Most investors will take on investments with high yield spreads because they offer higher returns.
What Is an Option-Adjusted Spread?
Options-adjusted spreads measure the spread between a fixed income annuity and the rate of return on a risk-free investment. Investors often use the options-adjusted spreads (OAS) to compare bonds that incorporate embedded options.
Options-adjusted spreads give investors insights on how embedded options impact a bond’s value. Typically, the OAS coverts mortgage-backed securities into yields to be calculated to form a spread to find an equal price.
What Is a Z-Spread?
The z-spread, also known as zero-volatility spread, determines the difference in yields an investor receives over the entire treasury spot rate.
The z-spread is a representation of added risk the investor is to take on from credit, liquidity and options. Z-spreads are typically larger because of the inclusion of all risk.
What Is an Example of a Spread?
Spreads in trading refer to the difference between the short position and a long position. There are three types of spread trades.
- Calendar spreads
- Calendar spreads are a futures strategy used by investors to enter into long or short positions with the same asset but, with different delivery dates.
- Inter-commodity spreads
- Inter-commodity spreads reflect the relationship of two different commodities. Traders will hold long positions on specific futures contracts and go short another commodity with the same delivery month.
- Option spreads
- Option spreads are the buying and selling of stock at different strike prices.
What Is a Bid-Ask Spread?
The bid-ask spread, also referred to as bid-offer, is the difference between the bid and the ask.
To break this down, first we have to understand what a bid is. A bid is the highest price offered of any financial instrument by the buyer. The ask is the lowest price the seller is willing to accept for a particular financial instrument.
If the bid-ask range is narrow, there’s a greater chance of getting the best price on the market orders placed. But, if the spread is wider, there’s a better chance to get a good price on the limit order.
What Influences a Bid-Ask Spread?
There are several factors that could affect the bid-ask spread, the most influential factor is volume. When buyers and sellers are looking to flip contracts quickly, the volume the shares have will influence the liquidity of the contracts.
For example, say the seller is holding onto a contract at $3.00. They would want to get out of this contract immediately in hopes of finding something better to invest in. They are going to want to sell their contract at or as close to $3.00.
If the contracts are exchanging rather quickly, the bid-ask spread will be more narrow. The investor could sell shares around $3.00. If there is less volume the bid-ask will widen which means the seller will not have the ability to sell shares at $3.00 quickly. Investors may even have to lower the ask price to get out of a contract.
Examples of a Bid-Ask Spread
So let’s break down the bid-ask price. Say an investor is looking to buy XYZ stock and a share has a current cost of $10.50. The investor is looking to only pay for share at $10.47. The spread of bid and ask price is $.03.
Therefore, the bid-ask spread is $.03 and this is what the broker takes as profit. This profit would also have to take fees into account.
What Is a Spread Risk?
Spreads come with a variety of factors that can cause investors to face risk on their investments.
- When compared to trading actual stock, profit is much lower. Investors are able to spend much less to enter trades but, this means their return on investment is going to be significantly less.
- Spreads are often not as liquid as a call or put. Securities that are less expensive do not hold as much volume. This means investors are not willing to trade these assets as quickly since they may lose money.
- This is a measure of how much the market price changes in a given period. During periods of high volatility, when prices change rapidly, the spread is usually much wider.
How Do You Make a Spread Trade?
When trading assets with a spread, a trader hopes for the market price to move out from it. If the market price moves beyond the spread the trader has the ability to get out of the trade and take profits.
Convertible Arbitrage Strategy
Convertible arbitrage is a market-neutral trading strategy that is used by hedge funds. It incorporates a long-short strategy that is used to capitalize on the pricing inefficiencies between the stock and the convertible.
To implement this strategy, the investor has to buy convertible securities and then short the purchase of the same common stock.
Pairs Trading Strategy
Investors looking to implement the Paris Trading strategy will have to pick two different assets and trade. These investors will want the relationship between the two assets stocks to vary from each other. Then the investors will hold a long and short position.
Investors mainly use this strategy open two positions to hedge against one another.
Fixed Income Arbitrage Strategy
Fixed-income arbitrage is an investment strategy that involves the purchase of assets at a low price to sell them at a higher price. It exploits pricing differentials between fixed-income securities.
In a fixed-income arbitrage strategy, the investor assumes opposing positions in the market to take advantage of small price discrepancies while limiting interest rate risk.
Are Trading Spreads Right for You?
It’s important for investors to have a good understanding on how spread trading works as well as its differences in strategies. This type of trading is a tool investors use to leverage their positions and increase profit. But with little knowledge on how spreads work, it’s a quick way for investors to lose money as well.
The market can be extremely volatile with many unpredictable events. It’s important to understand how much risk you are willing to factor into your portfolio before putting your money in the market. Before you decide to dive into this type of trading, learn how a financial advisor can help you to learn the basics of how to trade spreads.