What Is a Spread?
A spread in finance generally refers to the difference or gap that exists between two prices, rates, or yields. Here we’ll break down various types of spreads and how they can be utilized for profitable trading.
Key Takeaways
- A spread signifies the difference between two prices, rates, or yields.
- The most common type is the bid-ask spread, summarizing the gap between buyers’ bid prices and sellers’ ask prices for a security or asset.
- Spread trading embraces the gap between a short position in one contract and a long position in another, also called spread trade.
Understanding Spreads
Spread trading involves managing the gap between different financial instruments. This form of trade can apply to stocks, bonds, interest rates, and even underwriting processes.
In the world of financing, spreads demonstrate the risk, cost, and potential reward analyzed by investors and traders. For instance, in lending, the price a borrower pays over a benchmark yield depends on what’s called the ‘spread’.
Types of Spreads
Spreads are present across various financial instruments. Here are some of the most common:
- Bid-Ask Spread: Represents the gap between the highest price buyers are willing to pay (bid) and the lowest price sellers will accept (ask). Typically used to judge liquidity.
- Forex Spread: Influenced by factors like the liquidity of currency pairs, market conditions, and broker policies. Critical to understand as it affects trade cost.
- Interest Rate Spread Examples: Diversified categories exist within interest rate spreads, such as yield spread, option-adjusted spread, and Z-spread.
Infinite Strategies
Traders can use spread strategies to reap profits from various market movements—whether bullish, bearish, or neutral—depending on changes in the spread’s width.
Interest Rate Spreads
- Yield Spread: Difference in yields on differing debt instruments accounting for credit ratings and risk levels.
- Option-Adjusted Spread (OAS): Specific to bonds with embedded options such as MBS, requires analyzing securities into components.
- Zero-Volatility Spread (Z-spread): Determined by the present value of cash flows using spot rate Treasury curve for discounting.
Interest Rate Spread Example
Suppose an investor compares a corporate bond from Company XYZ yielding 5% and a U.S. Treasury bond at 3%. The yield spread would be 2%, showcasing the added return for taking on additional risk from the corporate bond over the stable U.S. Treasury.
Options Spreads
- Call and Put Spreads: These involve buying one call or put and simultaneously selling another under differing conditions expecting market shifts.
- Connected Activities: Techniques like long
Related Terms: options trading, futures contracts, credit risk, liquidity risk, market risk.
