Spreads in Finance: The Multiple Meanings in Trading Explained

What Is a Spread?

Few terms in finance are as potentially confusing as "spread." The word carries many meanings, and each is critical to understanding market dynamics and investing strategies. Spreads are important to know for nearly every aspect of financial markets, from the difference between bid and ask prices to more complex options strategies.

A spread in finance typically refers to some form of difference or gap between two related values. In stock trading, the spread generally refers to the gap between buying and selling prices. In bonds, it indicates the yield differential between two securities. Options traders use spreads to create sophisticated risk management strategies, while forex traders focus on currency pair differences.

Understanding these various types of spreads is crucial for anyone looking to navigate financial markets effectively. They impact the cost of trading and provide a greater understanding of market liquidity, risk, and potential profit opportunities. Below, we remove any confusion among these meanings while detaining their importance for investors.

Understanding Spreads

Spreads are the lifeblood of financial markets. They tell us about liquidity, risk appetite, and market efficiency all at once. Let's describe the major types in turn in the order we discuss them below:

1. Securities: The most common spread is the bid-ask spread. This is the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask). A narrow spread for stocks often indicates high liquidity and low transaction costs, while a wider spread suggests the opposite. Spreads can also refer to the gap between a short position (selling) in one futures contract or currency and a long position (buying) in another. This is officially known as a spread trade.
2. Bond market spreads: Bond yields spreads to measure the yield difference between two securities. The most well-known is the yield spread, which compares the interest rates of two bonds with different credit qualities or maturities. For instance, the spread between U.S. Treasury bonds and corporate bonds of the same maturity reveals the added yield investors demand for taking on the higher risk of corporate debt.
3. Lending: Spread refers to a borrower's price above a benchmark yield to get a loan. For example, if the prime interest rate is 3%, and a borrower receives a mortgage charging a 5% rate, the spread is 2%. From the institution's point of view, it's the difference between the interest rate it charges on loans and the interest rate it pays on deposits. This spread is a primary source of profit for banks and other lending institutions.
4. Options trading: Spreads have a different meaning in options altogether. Here, spreads refer to strategies involving multiple options contracts. These strategies, such as bull spreads or butterfly spreads, allow traders to fine-tune their risk exposure.
5. Foreign exchange (forex) markets: Here, spreads represent the difference between currency pairs' buy and sell prices. These spreads can fluctuate based on market volatility and liquidity.

1. Stock Market Spreads

Bid-Ask Spreads

Most securities sell in a two-sided market, such as most stocks, where there is a bid-ask spread that marks the difference between the highest bid price and the lowest offer. The bid-ask spread is often used to help assess a stock's liquidity.

For instance, in the stock market, a highly liquid stock like Apple Inc. (AAPL) may have a hypothetical bid price of $150.00 and an ask price of $150.02, resulting in a spread of just $0.02. This tight spread suggests a highly liquid market with many buyers and sellers. Meanwhile, a thinly traded stock, like a small-cap company, might have a bid price of $10.00 and an ask price of $10.50, resulting in a much larger spread of $0.50.

This wider spread shows lower liquidity, higher volatility, and greater transaction costs for traders. The bid-ask spread is crucial for high-frequency traders or market makers because their profit margins are often derived from these small differences.

Price Spread Between Securities

This spread is between the price of one stock and another. For example, the spread between the prices of common stock and preferred stock of the same company can reveal investor preferences and expectations regarding dividends, growth potential, and risk.

Similarly, the spread between different classes of stocks (such as Class A and Class B shares) can signal market sentiment about voting rights or control issues.

2. Bond Market Spreads

Spreads in the bond market are crucial indicators of risk, investor sentiment, and economic conditions. These spreads represent the difference between the yields of two bonds, typically reflecting varying levels of credit risk, maturity, or liquidity. Understanding bond spreads is essential for investors seeking to assess the risk-reward balance in their fixed-income portfolios.

Yield Spreads

Yield or interest rate spreads arise from the difference in yields between bonds of different types or groups, maturity dates, or issuers. A prominent example is the yield spread between long-term and short-term government bonds (e.g., the 10-year Treasury yield minus the two-year Treasury yield), known as the "yield curve spread." These spreads are calculated by subtracting the yield of one instrument from another and are typically expressed in basis points (bps) or percentage points.

Yield spreads are used as a starting point for determining why there are differences in yields because of maturity, issuer, or economic conditions. For instance, a widening yield curve spread often signals expectations of economic growth, while a narrowing spread suggests concerns about an economic downturn.

Credit Spreads

A type of yield curve spread, these are the yield differences between two bonds of similar maturity but different credit qualities, often expressed as the difference between a corporate bond and a risk-free government bond, such as a U.S. Treasury bond.

For example, if a 10-year U.S. Treasury bond yields 3% and a 10-year corporate bond issued by Company XYZ yields 5%, the credit spread is 2%. This spread compensates investors for the added risk of default associated with the corporate bond. A wider credit spread suggests higher perceived risk, often because of lower credit ratings or expectations of economic instability.

During the 2008 financial crisis (as seen in the chart below), credit spreads widened significantly as investors demanded more yield to compensate for the increased risk of corporate defaults.

Liquidity Spreads

This is the difference in yield between two bonds that are otherwise similar but differ in how much they are traded. A bond with lower liquidity will typically have a higher yield to compensate investors for the difficulty in buying or selling the bond quickly without affecting its price.

Liquidity spreads widen during market stress when investors prefer more liquid assets and narrow during periods of market stability.

Swap Spreads

The swap spread is the difference between the yield on a fixed-rate bond, such as a Treasury, and the fixed rate of an interest rate swap. This spread reflects the cost of swapping fixed-interest payments for floating ones and is used as a gauge of credit risk in the interbank market.

A widening swap spread can indicate increasing concerns about counterparty risk (the chance the other party will default) in the financial system.

Z-spread

The Z-spread (zero-volatility spread) is the constant spread that must be added to the risk-free Treasury yield curve to discount a bond’s cash flows back to its current market price. This spread is particularly useful for bonds with complex cash flows, such as mortgage-backed securities (MBS) or bonds with embedded options.

Let's take the example of a corporate bond trading at $105 with a face value of $100 and a 5% coupon rate. To determine the Z-spread, an investor would calculate the spread needed over the Treasury yield curve to make the present value of the bond’s cash flows equal to its market price. If the Z-spread is 1.5%, this means that over the entire Treasury yield curve, the bond offers an additional 1.5% yield to compensate for its credit risk and other factors.

The Z-spread is thus commonly used by fixed-income traders to assess the relative value of bonds, especially when comparing bonds with similar credit quality but different structures.

Option-Adjusted Spread (OAS)

The option-adjusted spread (OAS) refines the Z-spread by factoring in the impact of these options on the bond's value. Thus, it's the yield spread that investors would receive over a risk-free rate if a bond did not have any embedded options, such as call or put options.

Suppose there's a callable bond issued by Company ABC with a 10-year maturity and a 6% coupon. The bond might trade with a Z-spread of 2%, but because the issuer has the option to call the bond after five years, the OAS might be lower, say 1.5%, after adjusting for the call option's value.

This gives investors a clearer picture of the bond's real credit risk and liquidity, excluding the distortions caused by the embedded options. Investors use the OAS to compare bonds with different embedded options.

3. Lending Spreads

Lending spreads are the difference between the interest rate a lender charges borrowers and the lender’s cost of funds. While bond spreads are covered earlier in this article, lending spreads focus specifically on the margins in various types of loans, such as mortgage, personal, and corporate loans. They are a crucial measure of profitability for financial institutions since they represent the margin earned on loans after accounting for the cost of borrowing money to fund those loans. Here are the main types:

• Bank lending spread: Also called the net interest margin, this compares the interest rate on loans issued by banks (such as mortgages or commercial loans) to the rate at which the bank borrows funds, often measured against a benchmark rate like the federal funds rate. A wider bank lending spread reveals more profits, as it earns more on its loans than its borrowing costs. Conversely, a narrow spread suggests increased competition or higher funding costs, which can squeeze margins.
• Mortgage Spread: In the mortgage market, the spread between mortgage and benchmark rates (like the yield on 10-year Treasury bonds) reflects the risk premium and cost of originating and servicing mortgage loans. Credit risk, market liquidity, and economic conditions all influence this spread. A wider mortgage spread reveals a more cautious lending environment since lenders are charging more to compensate for perceived risks.
• Corporate loan spread: This measures the difference between the interest rates charged on corporate loans and the rates at which the lending institution borrows funds. A widening corporate loan spread signals increased credit risk or economic uncertainty as with the other spreads here.
  

4. Options Spreads

Option spreads are trading strategies that involve simultaneously buying and selling two or more options contracts on the same underlying asset, typically with different strike prices, expiration dates, or both. These strategies are designed to limit risk, cut the cost of entering a trade, or increase the potential for profit under specific market conditions. Option spreads can be used for the full range of market scenarios. These are some of these spreads:

Call Spreads

One type of call spread, the bull call spread, is an options trading strategy designed for traders who expect a moderate rise in the price of the underlying asset. The strategy involves buying a call option with a lower strike price and simultaneously selling a call option with a higher strike price, both with the same expiration date. The purchased call option provides the right to buy the asset at the lower strike price, while the sold call option obligates the trader to sell the asset at the higher strike price if exercised.

For example, suppose a stock is trading at $50. An investor expecting the stock to rise might buy a call option with a strike price of $50 for a premium of $3 and sell a call option with a strike price of $55 for a premium of $1.

The net cost of the spread is $2 ($3 paid for the long call minus $1 received for the short call). The maximum profit is $3, which occurs if the stock price is at or above $55 at expiration (the difference between the strike prices minus the net premium paid). The maximum loss is limited to the $2 net premium paid, which occurs if the stock price remains at or below $50. This strategy provides a way for traders to benefit from a rise in the stock price while limiting potential losses, so when placed side by side with outright buying a call option, it is more balanced.

5. Put Spreads

A bear put spread is used by traders who expect a moderate decline in the price of the underlying asset. This involves buying a put option with a higher strike price and selling a put option with a lower strike price, both with the same expiration date. The long put option provides the right to sell the asset at a higher strike price, while the short put option obligates the trader to buy the asset at a lower strike price if exercised.

For example, suppose an investor believes that the stock price of XYZ Company, currently trading at $52, will decrease soon. They carry a bear put spread to profit from this potential decline. The investor buys one put option with a strike price of $50 (higher strike) and sells one put option with a strike price of $45 (lower strike). Both options have the same expiration date.

• The premium received for selling the $45 put is $1.00
• The premium paid for buying the $50 put is $5.00
• The net premium paid (debit) is $4.00 or $400 total ($4.00 x 100 shares per contract)

The potential results are below:

A bull put spread is an options trading strategy that investors use when they have a moderately bullish outlook on an underlying asset. This vertical spread (those that buy and sell options of the same type) involves simultaneously selling a put option at a higher strike price and buying a put option at a lower strike price, with both options having the same expiration date. The goal is to profit from a rise in the underlying asset's price or from staying stable above the higher strike price. This strategy allows traders to generate income through the premium from selling the put option while the purchased put works as a hedge to limit potential losses.

The maximum profit for a bull put spread is achieved if the underlying asset's price closes above the higher strike price at expiration, allowing both options to expire worthless and the trader to keep the entire net premium received. The maximum loss occurs if the asset's price falls below the lower strike price, but this loss is capped and known in advance. Below is a chart depicting the possible results of this strategy.

Long Butterfly Spread

A long butterfly spread combines call and put options to capitalize on low volatility in the underlying asset. It's constructed by buying one in-the-money option, selling two at-the-money options, and buying one out-of-the-money option, all with the same expiration date. The strategy can be executed using all call options or all put options.

For example, suppose an investor expects the stock price of XYZ Company, trading at $50, to remain relatively stable in the near future. They employ a long butterfly spread strategy to potentially profit from this stability.

The investor buys one put option with a strike price of $45, sells two put options with a strike price of $50, and buys one put option with a strike price of $55. All options have the same expiration date.

• The premium received for selling the two $50 puts is $2.00 each, totaling $4.00
• The premium paid for buying the $45 put is $0.50
• The premium paid for buying the $55 put is $4.50
• The net premium paid (debit) is $1.00 or $100 total ($1.00 x 100 shares per contract)

The potential outcomes are below:

Calendar Spread

A calendar spread, also known as a time spread, involves buying and selling options with the same strike price but different expiration dates. Typically, an investor buys a longer-term option and sells a shorter-term option. The strategy profits from the differing rates of time decay (the decline in value of an option as it approaches expiry) between the two options. It is used when the trader expects little movement in the asset’s price in the short term but potentially significant movement later on.

For example, suppose an investor is trading options on stock XYZ, trading at $100. You buy a call option on a stock expiring in six months with a strike price of $100 for a premium of $8 and simultaneously sell a shorter-term call option on the same stock with the same strike price but expiring in one month. The net cost of the options is $5. The strategy profits as the near-term option (the short leg) decays faster than the long-term option, which could increase in value if volatility rises.

The maximum profit typically occurs when the underlying asset is at the strike price at the expiration of the short-term option, allowing the trader to benefit from the time decay of the sold option. However, there's a risk that the underlying asset shifts significantly in the short term, making the trader exercise the short leg, leading to losses.

Box Spread

A box spread is an arbitrage strategy that involves creating both a bull call spread and a bear put spread on the same underlying asset, effectively creating a synthetic long or short position with no risk. This strategy is designed to take advantage of mispricings in the options market and lock in a risk-free profit. The box spread pays off a fixed amount whatever the underlying asset’s price at expiration.

Suppose an investor notices a mispricing in the options market for a stock trading at $50. They might create a box spread by doing the following:

• Buying a call option with a strike price of $50 for a premium of $4
• Selling a call option with a strike price of $60 for a premium of $2
• Buying a put option with a strike price of $60 for a premium of $9
• Selling a put option with a strike price of $50 for a premium of $7

The net cost of this box spread is $4 ($4 + $9 - $2 - $7). The payoff from the box spread at expiration is the difference between the two strike prices ($60 - $50 = $10). Since the cost of entering the position is $4, the risk-free profit is $6. However, box spreads require careful execution and are often used by institutional investors because of their complexity and the need for large capital to make the strategy worthwhile, considering the transaction costs.

Spread Risks

As with any other trade in the market, spread trading comes with market risk, the adverse effects should the underlying stock's price not move your way. For example, if a trader enters into a bull call spread on a stock that they believe will rise in price and instead it drops, they might lose on the strategy. Market risk can result in early assignment (the right that comes when the option is exercised), particularly with short options positions. Early assignment can disrupt the intended structure of your spread, potentially leading to unexpected losses or complications in managing your positions.

Here are other risks involved with spreads:

• Liquidity risk can make entering or exiting positions more difficult for traders, resulting in wider spreads and increased costs.
• Volatility risk plays a significant role in spread strategies. Unexpected changes in implied volatility can dramatically affect the value of a spread position, sometimes in counterintuitive ways. For instance, an increase in volatility might benefit long options positions while hurting short positions within the same spread.
• There's also the risk of misunderstanding or mismanaging the strategy itself. Spread strategies can be complex, and traders may miscalculate break-even points, maximum loss scenarios, or margin requirements. This can lead to unexpected outcomes, especially when market conditions shift quickly.

6. Forex Spreads

Forex spreads are the differences between the bid price (the price at which you can sell a currency pair) and the ask price (the price at which you can buy a currency pair). This spread is essentially the cost of trading and the primary way that forex brokers make money. The size of the spread depends on market liquidity, volatility, and the specific currency pair being traded.

Major currency pairs like EUR/USD typically have tighter spreads because of high liquidity, while exotic pairs may have wider spreads. For traders, especially those engaged in short-term strategies like day trading or scalping, the spread is a crucial consideration as it directly affects the profitability of each trade. Wider spreads mean a trade needs to move further in the trader's favor just to break even. Some brokers offer fixed spreads, while others provide variable spreads that fluctuate with market conditions.

The Bottom Line

In finance, a spread refers to the difference or gap between two prices, rates, or yields. A common one is the bid-ask spread, which is the gap between the bid (from buyers) and the ask (from sellers) prices of a security, currency, or other asset. A spread can also refer to the difference in a trading position, such as the gap between a short position (selling) in one futures contract or currency and a long position (buying) in another, known as a spread trade.

In lending, the interest rate spread between what banks pay depositors and what they charge borrowers is a key determinant of profitability. For investors, yield spreads between different bonds, such as corporate bonds and government securities, help gauge market risk perceptions. Across all these applications, spreads serve as essential indicators of market conditions, risk, and potential profitability, making them a cornerstone of financial analysis.