Spreads in Finance: The Multiple Meanings in Trading Explained

What Is a Spread?

A spread can have several meanings in finance. Generally, the spread refers to the difference or gap that exists between two prices, rates, or yields.

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. Bond investors look at the spread-to-worst (STW) when comparing securities with similar durations.

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.

Interest Rate Spreads

• A yield spread is the difference between yields on differing debt instruments of varying maturities, credit ratings, issuer, or risk level, calculated by deducting the yield of one instrument from the other. This difference is most often expressed in basis points (bps) or percentage points. Yield spreads are commonly quoted in terms of one yield versus that of U.S. Treasuries, where it is called the credit spread. Some analysts refer to the yield spread as the “yield spread of X over Y.” This is usually the yearly percentage return on investment of one financial instrument minus the annual percentage return on investment of another.
  
• The option-adjusted spread (OAS) measures the difference in yield between a bond with an embedded option, such as an MBS, with the yield on Treasuries. It is more accurate than simply comparing a bond’s yield to maturity to a benchmark. By separately analyzing the security into a bond and the embedded option, analysts can determine whether the investment is worthwhile at a given price. To discount a security’s price and match it to the current market price, the yield spread must be added to a benchmark yield curve. This adjusted price is called an option-adjusted spread. This is usually used for mortgage-backed securities (MBS), bonds, interest rate derivatives, and options. For securities with cash flows that are separate from future interest rate movements, the option-adjusted spread becomes the same as the Z-spread.
• The zero-volatility spread (Z-spread) is the constant spread that makes the price of a security equal to the present value of its cash flows when added to the yield at each point on the spot rate Treasury curve where cash flow is received. It can tell the investor the bond's current value plus its cash flows at these points. The spread is used by analysts and investors to discover discrepancies in a bond's price. The Z-spread is also called the yield curve spread and zero-volatility spread. The Z-spread is used for mortgage-backed securities. It is the spread that results from zero-coupon treasury yield curves which are needed for discounting pre-determined cash flow schedule to reach its current market price. This kind of spread is also used in credit default swaps (CDS) to measure credit spread.

Interest Rate Spread Example

Suppose an investor is considering two bonds: a corporate bond issued by Company XYZ with a yield of 5%, and a U.S. Treasury bond with a yield of 3%. The yield spread in this case would be 2% (5% - 3%), indicating that the corporate bond is yielding 2% more than the U.S. Treasury bond.

If the investor believes that the risk of default on the corporate bond is low and the company is financially sound, they might decide to buy the corporate bond and sell the U.S. Treasury bond, in order to profit from the yield spread. This would be known as a "yield spread trade."

If the investor's assessment of the credit risk of Company XYZ is correct and the bond performs as expected, they will earn the 5% yield on the corporate bond and realize a profit from the yield spread of 2%. However, if the credit risk of Company XYZ turns out to be higher than expected and the bond defaults, the investor could lose their entire investment in the bond. This is why it is important for investors to carefully consider the credit risk of any bond before entering into a yield spread trade.

Options Spreads

• Call spreads involve simultaneously buying and selling different calls on the same underlying. A bull call spread earns profit when the underlying rises while a bear call spread does so when the underlying falls.
• Put spreads are similar but involve put options instead of calls. Like call spreads, there are bull put spreads and bear put spreads.
• A long butterfly is a neutral to bullish strategy involving the simultaneous purchase of two options with lower strike prices, the sale of one option with a higher strike price, and the sale of another option with an even higher strike price. The goal is to profit from a narrow range of movement in the underlying asset. Variations if the butterfly include the condor, iron butterfly, and iron condor.
• Calendar spreads are a strategy involving the simultaneous purchase of an option with a longer-term expiration date and the sale of an option with a shorter-term expiration date on the same underlying asset. The goal is to profit from a difference in the rate of time decay between the two options.
• A box spread, or long box, is an options arbitrage strategy that combines buying a bull call spread with a matching bear put spread. A box spread can be thought of as two vertical spreads that each has the same strike prices and expiration dates, and will always be worth the distance between the strike prices at expiration,

Options Spread Example

An illustrative example of a spread used in trading is a bull call spread. This is a bullish options trading strategy that involves the purchase of a call option with a strike price that is below the current market price, and the simultaneous sale of another call option with a higher strike price.

For example, let's say that XYZ stock is currently trading at $50 per share. An investor who is bullish on XYZ stock might buy a call option with a strike price of $45 per share and sell a call option with a strike price of $55 per share. The goal of this bull call spread is to profit from an upward move in the price of XYZ stock, while limiting the potential loss if the stock does not move as expected.

If XYZ stock rises to $60 per share, the call option with the strike price of $45 per share would be in the money and have a value of $15 per share ($60 market price - $45 strike price). The call option with the strike price of $55 per share would also be in the money, but with a value of only $5 per share ($60 market price - $55 strike price). The net profit for the investor in this case would be the difference between the two options, or $10 per share.

If XYZ stock does not rise above the strike price of the call option that was sold (in this case, $55 per share), then both options would expire worthless and the investor would lose the premium paid for the call option that was purchased. This is why the bull call spread is considered a limited risk strategy.

Spread Risks

Spread trading, like any other form of trading, carries a number of risks that traders and investors should be aware of. For example, market risk can affect the value of the underlying assets and the profitability of the spread trade. Thus, if a trader enters into a bull call spread on a stock that they believe will rise in price, but the stock's price unexpectedly drops due to market conditions, the trader may suffer a loss on the spread trade. Likewise, if you bet that a spread will narrow but it widens, you can lose money.

In addition, there are other potential risks involved with spreads:

• Liquidity risk can make it more difficult to buy or sell assets as needed, resulting in wider spreads and increased trading costs.
• Credit risk can be a concern when spread trades involve the use of leverage or the trade of securities with lower credit ratings, as the risk of default or credit events can lead to significant losses.
• Volatility risk can make it more difficult to accurately predict the direction and magnitude of price movements, which can impact the profitability of a spread trade.
• Counterparty risk can also be an issue, as spread trades may involve the use of derivatives or other financial instruments that rely on the creditworthiness of a counterparty. If the counterparty fails to meet its obligations, the trader or investor may suffer significant losses.

The Bottom Line

In finance, a spread refers to the difference or gap between two prices, rates, or yields. One common use of "spread" is the bid-ask spread, which is the gap between the bid (from buyers) and the ask (from sellers) prices of a security or 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. Spreads can also refer to the difference in the amount paid to the issuer of a security and the price paid by the investor for that security in underwriting, or the price a borrower pays above a benchmark yield to get a loan in lending. There are several different types of spreads, including yield spreads, option-adjusted spreads, and Z-spreads, which are used in different contexts in finance.