The spread is the difference between the bid and ask price of a currency, commodity, or index. We can also define it as the difference between a buying and selling price. Hence, it’s known as the brokers’ profit.
In one of the most common definitions, the spread is the gap between the bid and the ask prices of a security or asset, like a stock, bond, or commodity. This is known as a bid-ask spread. Spreads can also be constructed in financial markets between two or more bonds, stocks, or derivatives contracts, among others.
Understanding Spreads
Spreads can also refer to the difference in a trading position – the gap between a short position (that is, selling) in one futures contract or currency and a long position (that is, buying) in another. This is officially known as a spread trade.
In underwriting, the spread can mean the difference between the amount paid to the issuer of a security and the price paid by the investor for that security—that is, the cost an underwriter pays to buy an issue, compared to the price at which the underwriter sells it to the public.
In lending, the spread can also refer to the price a borrower pays above a benchmark yield to get a loan. If the prime interest rate is 3%, for example, and a borrower gets a mortgage charging a 5% rate, the spread is 2%.
The spread trade is also called the relative value trade. Spread trades are the act of purchasing one security and selling another related security as a unit. Usually, spread trades are done with options or futures contracts. These trades are executed to produce an overall net trade with a positive value called the spread.
Types of Spreads
Spreads exist in many financial markets and vary depending on the type of security or financial instrument involved.
In many securities that feature a two-sided market, such as most stocks, there is a bid-ask spread that appears as the difference between the highest bid price and the lowest offer. The bid-ask spread is often used to judge a stock’s liquidity.
Bid-ask spreads also feature prominently in forex trading and can vary depending on a number of factors, including the liquidity of the currency pair, market conditions, and the broker’s own pricing policies. Some brokers charge fixed spreads, while others charge variable spreads that can fluctuate based on market conditions. It’s important for traders to understand the spreads that they are being quoted, as they can have a significant impact on the overall cost of a trade.