At first glance, the stock market seems like an intricate machine that only the professionals know how to use. Much of the confusion that keeps the average person from taking advantage of the wealth-building power Wall Street has to provide comes from the fact that the market comes with its own lingo.
Thankfully, as you start to learn the language, you’ll find investing isn’t quite as difficult as you thought.
One of the terms beginner investors come across often is known as the spread. “Spread” is one of a few stock market terms that mean different things when used in different contexts. Understanding what is meant by a spread in investing can tell you a lot about what you’re investing in and your trading costs.
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What Is a Spread in Investing?
The term spread is used in statistics to define the difference between one measurement and another on similar objects or points of data. For example, if one watermelon weighs five pounds and another weighs six pounds, the weight spread between these watermelons is one pound.
On Wall Street, the term spread is applied to a wide range of financial instruments and investing strategies. Depending on how the term is used, it has different meanings. Here are the common ways a spread is referred to in the stock market:
The most common use of the term spread in the stock market refers to the bid-ask spread. The bid-ask spread compares the following:
- Bid Price. The bid price is the amount of money a buyer is willing to pay for a financial instrument they’re considering investing in, such as a share of stock.
- Ask Price. The ask price is the amount of money a seller of a financial instrument is willing to accept in order to execute the sale.
The difference between the bid price and the ask price is known as the bid-ask spread. In other words, the bid-ask spread is the difference between buyers’ maximum price and sellers’ minimum price. Importantly, stock brokers often bake commissions into bid-ask spreads. So, even a commission-free broker may not be fully free because their fees may be baked into their bid-ask spreads.
Although stocks, exchange-traded funds (ETFs), contracts for difference (CFDs), forex currency pairs, and any other exchange-traded asset generally comes with a bid-ask spread, mutual funds don’t. This is because of how mutual fund transactions take place. Buy and sell orders on mutual funds are not filled until the fund’s price for the day has been posted, which generally happens a couple hours after the close of the stock market.
Yield spreads relate to debt instruments like corporate bonds, municipal bonds, and treasury bills. These spreads represent the different rates of return on similar debt instruments with differences like:
- Maturity Dates. Imagine one corporate bond has a maturity date of five years and a coupon rate, or interest rate, of 5%. Another corporate bond has a maturity date of seven years and a coupon rate of 7%. In this case, the yield spread between the two investing options is 2%.
- Credit Rating. As is the case with consumer debt, when companies or governments issue bonds and other debt instruments, they pay an interest rate to lenders. One of the primary determining factors for that interest rate is the issuer’s credit rating. For example, one issuer with a good credit rating issues a three-year bond with a coupon rate of 5%, and another issuer with a fair credit rating issues a three-year bond with a coupon rate of 7%. The yield spread between the two is 2%, meaning investors in the bond from the issuer with the lower credit rating are compensated for the increased risk with a 2% increase in the potential return the bond offers.
- Risk Level. Although credit ratings play an important role in the pricing of debt instrument interest rates, there are several factors that play into the risk level. For example, two companies may have the same credit rating, but one has a relatively new business model while the other has a business with a tried-and-true track record of success. The new business will likely pay a higher coupon rate than the established issuer, offering up a positive yield spread in order to entice investors to accept the increased risk.
Option spreads are an important piece of most options trading strategies. Spread trades provide a way for options traders to reduce risk by simultaneously buying and selling options of the same security with different strike prices or expiration dates. As a derivative investment, options traders never own shares of the underlying assets. Using options and spread trading is a more complex trading strategy and is not usually best for beginner investors. But when options traders talk about option spreads or spread positions, they’re generally talking about hedging their bets by buying and selling pairs of option positions.
For example, let’s say a stock is trading at $162 per share. An investor might buy a $160 call for $3.50 and sell a $165 call for $1; this would bring the investor’s net cost to $2.50 per contract. If the stock rose above $165 by the end of the month, the spread would be worth $5, leading to 100% profits. On the other hand, if the stock fell to $160, the spread would become worthless, meaning the investor would take a 100% loss.
Investment Banking or Underwriting Spreads
Finally, spreads can also relate to transactions between a stock issuer and an investment bank or underwriter. When an issuer of stock decides to issue new shares, they don’t generally sell them directly to the investing public. Instead, there’s an underwriter involved.
Underwriters are financial professionals who work with the issuer to determine fair share prices and help to facilitate the offering. In exchange for their work with the issuer, the underwriter or investment bank receives a discount on the shares in the offering and then sells them to the investing public.
For example, an issuer may decide to sell 1 million shares at a price of $10 per share. In exchange for the work they put into the deal, the underwriter is able to purchase the shares at $9 per share before selling the shares to their customers at the offering price of $10 per share. Through this deal, the underwriter spread on the shares of stock is $1, meaning once all 1 million shares are sold, the underwriter earns a total of $1 million.
What the Spread Tells You
It’s important to pay close attention to the spreads associated with your investments because they tell you quite a bit about the underlying assets.
How Actively a Stock Is Traded
The bid-ask spread will vary from stock to stock, ETF to ETF, and across any other type of exchange-traded security. The cause of the difference is largely liquidity, — how many buyers and sellers there are of that particular security — making the bid-ask spread a de facto measure of liquidity and volatility.
When an exchange-traded security has a large bid-ask spread — a large difference between buyers’ open offers and sellers’ asking prices — it means there’s not much trading on that security. As such, when you see a large bid-ask spread, it’s a sign you may have difficulty selling the security in a reasonable amount of time if you decide you want out of it.
On the other side of the coin, when a security has a low bid-ask spread, it means the security is very actively traded. As a result, the security will be highly liquid, meaning you’ll likely find it easy to sell the security whenever you decide to exit your position.
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The yield spread outlines yield differences between comparable debt instruments. This is important because the yield spread outlines the increased return you’ll receive as a result of various factors:
- Reduced Liquidity. First and foremost, longer-term debt instruments tend to pay higher interest rates. The drawback is that the longer the term on the debt instrument, the less liquid that instrument becomes. So, the increased yield on longer-term debt instruments is essentially payment for being willing to hold your money in the investment for a longer time.
- Increased Risk. Yield spreads also make the increased potential return clear when it comes to making a decision between debt instruments with different levels of risk. These risks include lower creditworthiness, lack of operating experience, balance sheet issues, or a wide range of other risks.
Ultimately, before buying any debt instrument, it’s important to gauge the risk and reward associated with the investment. The yield spread adds a level of simplicity to doing just that.
As mentioned above, commission-free trades aren’t necessarily free. Although there is no upfront commission on these trades, small fees are often baked into the spread, providing the broker with a way to generate revenue on these so-called free trades.
This activity is most prevalent when it comes to forex brokers. As a result, before working with a forex broker, it’s important to look into the spreads because some brokers will charge outsize bid-ask spreads on all trades, essentially using a roundabout way to take advantage of unsuspecting investors.
Research forms the basis of most successful investing decisions. When doing your research, it’s common to look into the company’s business model, finances, and historic performance. However, there are other factors to look into as well, with spreads being an important part of the process.
Spreads keep you abreast of the fees you’ll pay when trading exchange-traded securities as well as the returns you’ll receive in comparison to other investment options when investing in debt obligations. Moreover, they provide you with information surrounding the popularity of securities you’re interested in buying and whether you’ll be able to sell them quickly when it’s time to exit your position.