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By Will Ellis

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Last Updated on January 5, 2024

For any novice investors out there, you’d generally be forgiven for assuming that a financial spread is essentially just the numerical difference between two separate values, as while this is still true, it doesn’t exactly represent the full picture.

In reality, financial spreads play a much bigger role in the world of trading since they tend to be used as crucial indicators about some market dynamics before you enter a trade — demonstrating things like volatility, risk, and potential profit.

Having said this, financial spreads are mostly a concept that only experienced investors actually have a grasp on, which is slightly problematic given how much an understanding of how it works can influence how profitable a trader you are.

So, to level the playing field slightly, we’ll be breaking down all you need to know about financial spreads throughout this article — covering what they are, how they actually work, and what kind of part they play in managing your risk and maximising your returns as an investor.

Table of Contents:

• The Foundation: Bid-Ask Spread
• Spread Trading: Strategies and Techniques
• Beyond Stocks and Bonds: Spreads in Other Markets
• FAQs

The Foundation: Bid-Ask Spread ➡️

To kick things off, let’s walk through some of the fundamentals that are worth getting your head around:

Two Prices, One Market

In essence, the bid-ask spread makes up a major part of every financial transaction. For example, whenever you look at a certain price quote for a security — regardless of what trading platform you are using — you’ll see there are actually two distinct prices, which are commonly referred to as the bid price and the asking price.

So, say the bid price is $30 and the ask price is $31, then the bid-ask spread would be $1. For a bit more clarity here, the bid price basically just means the highest amount that any given buyer is willing to pay for the security — the ask price, on the other hand, is the lowest amount that a seller would accept for the trade.

So, the bid-ask spread is the difference between both of these prices, and this acts as a kind of compensation for the market maker who enables you to buy and sell all of these financial instruments in the first place.

Market makers attempt to then profit from this spread, offering liquidity to the market by standing ready to buy or sell securities at the quoted prices.

Widening Horizons: Wide Bid-Ask Spreads and Fixed Spreads

Generally speaking, the variation in market conditions you’ll often find yourself experiencing makes it pretty essential to know how bid-ask spreads work — especially if you’re attempting to trade in a bit more volatile or just bearish market price action.

So, in terms of how you can actually read these spreads, let’s look at a few common examples. You’ll probably encounter a wide bid-ask spread quite a lot when you’re using a trading platform (whether you’re trading cryptocurrency or more traditional assets like stocks and shares), and this tends to mean there’ll be lower liquidity and even higher transaction costs.

For any of the novice investors currently reading this article, you’d generally never want to approach these kinds of trading scenarios, as some fees you will end up taking on will ultimately diminish a lot of the profits you could make.

Having said that, sometimes the bid-ask spread can work out fairly positively for you as a trader, as a lot of the time, markets feature something known as a fixed spread, which is basically when the difference between the bid and ask prices always stays the same. Naturally, this makes a lot of the transaction costs a lot more predictable, so it’s much easier to trade with and stay organised in terms of how much money you’re spending.

Spread Trading: Strategies and Techniques ➡️

Moving forward, let’s explain in a little more detail how you can take advantage of whatever the bid-ask spread currently looks like and execute a profitable trade:

Spread Trading Demystified

The bid-ask spread is obviously pretty fundamental to trading, but some of the more advanced strategies out there involve the concept of spread trades instead, and this is essentially when you try to simultaneously buy and sell some financial instruments that are related to each other with the hopes of making money on the relative price movements between them.

Again, this is definitely fairly advanced as far as trading strategies go, so if you’re a novice investor who seems slightly overwhelmed by this concept, it’s certainly understandable — just slowly start to build some experience by attempting to spread trade.

Relative Value Trade: Comparing Apples to Oranges

There are actually a few different ways you can spread trade, and one of the more popular methods is with the relative value trade, which is essentially when you’re comparing the value of one security against another one — whether it’s things like stocks, bonds, or even entirely different asset classes like the cryptocurrency market.

Ultimately, the aim is to try to profit as the prices converge once you’ve identified any possible mispricings between some related financial instruments.

Zero Volatility Spread: Navigating Options

If you’ve ever traded options before, you might’ve encountered something called the zero volatility spread, and this is just one of the strategies investors use to try to capitalise on some discrepancies in implied volatility.

The phrase ‘implied volatility’ might sound a little convoluted, but this is basically just a reference to the market’s expectations for any potential price fluctuations in the future.

So, to get specific, the zero volatility spread would involve you buying and selling certain options that have different strike prices and expiration dates at the same time, ultimately aiming to benefit from any of the changes in volatility.

Yield Curve Spread: Decoding Fixed Income

Aside from options, there are concepts like yield spread that are also worth understanding for anyone who might be thinking about venturing into the bond market in particular.

In essence, this specific spread measures what the difference in yield is between different bonds or even between a bond and a benchmark (such as a government bond, for instance).

There’s a lot of credit risk involved when investing, so being able to use yield spreads to assess it can definitely help you make informed investment decisions.

Furthermore, if you see the phrase ‘option adjusted spread‘ (OAS) anywhere, this just accounts for any of the embedded options in the bond, things like call or put options, for example.

Credit Spread: Gauging Credit Risk

Finally, another major part of trading in fixed income markets is the credit spread, which basically represents what the additional yield demanded by the investors is, given that they’ve had to bear the credit risk of a particular issuer.

Again, this can be a pretty good way of gauging the market conditions before jumping into a trade, as widening credit spreads tend to signal that the perceived risk has slightly increased, while narrowing spreads, on the other hand, usually mean that credit conditions are getting better.

Beyond Stocks and Bonds: Spreads in Other Markets ➡️

We’ve touched on this a few times throughout the article already, but various other markets like the derivatives and currency markets also use spreads — it’s not only exclusive to the more traditional forms of investing like stocks, bonds, and options.

So, let’s walk through the other scenarios where you might use spreads in another market:

Futures Contracts: Spreading the Risk

It’s a pretty similar strategy to how you’d trade options, but a futures spread is when you buy and sell futures contracts at the same time, and they usually have different expiration dates.

Of course, this kind of strategy is best used when you’re anticipating any changes in the price relationship between the two contracts.

Currency Market: Spreading Across Borders

Currencies get quoted in pairs, and the bid-ask spread actually plays a fairly crucial role in forex trading. As with all the other assets we’ve mentioned thus far, understanding how currency spreads work is vital for successful trading in the foreign exchange market.

FAQs 📢️

Are There Risks Associated With Relying Solely on Spread Analysis for Trading Decisions?

Naturally, you’d never want to put all of your eggs in one basket and only ever use spread analysis as your due diligence before entering a trade. You’d be much better off taking a more comprehensive approach and combining spread analysis with other kinds of indicators and market factors so that you’re using insights from multiple different angles.

How Do News and External Events Impact Financial Spreads?

Generally speaking, the news and other external events across the world have always had an impact on the financial markets — from sudden developments that have transpired from economic reports or even geopolitical events, the increased volatility can definitely affect spreads. As such, you always want to stay informed about these kinds of events to adapt your trading strategy accordingly.

Can Automated Trading Systems Leverage Financial Spreads Effectively?

Absolutely, and although it may take some getting used to at first, an automated trading system can certainly help leverage financial spreads. Put simply, algorithms can be programmed to analyse all the spreads in real-time, so any trades you want to make can be executed automated if you provide it with a few predefined parameters — naturally helping you respond faster to market changes.

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