Spread Trading? What is the Spread?
Spread trading in general refers to the practice of playing both sides of a trade, which is typically done utilizing the options or futures markets to “hedge” a position, or buy insurance/protection against a pullback move. Spread trading involves buying a long position, in addition to a short position. This could be for different dates, different prices, one in common stock with the other in options, etc. Spread trading is an advanced trading strategy, so if you’re still learning your way around the markets, stick to the basics.
As for the basics, the bid/ask spread can sometimes be confused with spread trading, but isn’t the same beast. The “bid” and “ask” prices are two important figures that are associated with stocks and securities. The bid is the maximum price someone is willing to offer to pay for a share of that stock (highest bidder kinda thing). The ask is the minimum price someone is willing to sell each share of stock for. Simply put, the bid represents the price from a buyer’s point of view, while the ask represents the price from a seller’s point of view. The difference between the bid and the ask is known as the “Bid/Ask Spread.”
If you’re still not sure of what you just read, think of it like this: If you decide to sell shares of ABC company’s stock, your sell price is the bid. If you buy shares of ABC company, you pay the ask. “Sell the bid, buy the ask.”
Every exchange (NYSE, AMEX, NSDQ, etc.) has specific entities that are called “market makers” (there’s thousands in the US alone). The job of a market maker throughout the trading day is to continuously post both an ask and a bid price for a specific stock. By posting continuously to buy or sell a stock, market makers ensure there is always someone ready to execute a trade with an investor, should the investor want to buy or sell shares. Market makers have strong influence on price action, and many are spread trading (playing both sides), as mentioned before.
Should an investor decide to sell shares that he owns, he expects to get the bid price. Should he want to buy more, he expects to get the ask. Without market makers, that same investor may not be able to find someone to sell him shares, or buy the shares that he is willing to sell. Therefore, a market maker is essentially “making a market”, and assisting to maintain stock liquidity.
What The Spread Really Represents
If you sell shares of a stock and no one is willing to buy, the market makers are essentially the ones purchasing the shares from your broker. The market makers are always prepared to take the buy or sell end of a trade, and they are required by law to fill orders at the bid and ask prices that they post.
Keep in mind, that investors can sell shares (to market makers) at the lower price (the bid) and investors can buy those same shares (from the market maker) at the higher price (the ask.) Market makers buy low and sell high, and pocket the difference between the bid and the ask. When establishing the bid/ask spread for a specific stock, market makers signal how much they want to be paid for “making the market” for that stock.
Why should the market maker deserve to be paid? In “making the market”, a market maker must be ready at any time to take the chance of holding stock that it is “making a market” in. The overall risk is that market makers can potentially buy stock without being able to sell to another investor later. Simply put, the risk of “making a market” really depends on the potential for any price swings that could occur suddenly while a market maker is holding a specific stock. The greater the risk, the wider the spread between the bid/ask.
Factors That Can Determine The Spread
The 3 major factors that can determine spread size are volatility, liquidity, and stock price. Stocks that are illiquid, stocks traded during times of volatility in the market, and stocks that are cheap will usually all have wider spreads.
Sudden price swings within the market is referred to as “volatility.” It happens when there are substantial imbalances in supply and demand. In times of increased market volatility, stocks will show wider spreads as market makers expect more compensation for having to be prepared to trade a security whose price is greatly fluctuating. A market maker may also post wider spreads in such times in order to decrease the overall volume of trading.
A stock that is liquid is a stock trading at higher volumes, while an illiquid security isn’t trading much at all. Liquidity also refers to the degree to which a stock can be bought or sold without fluctuation in the security’s price.
When there is high supply and demand for a security, large buy or sell orders for that stock don’t have as much effect on the stock price. Liquid stocks usually have much narrower bid/ask spreads. The more volume, the faster and easier it is for market makers to “make the spread.” On a similar level, because of high volume, a security that is liquid will usually have several market makers competing in that stock. The market maker that posts the most attractive bid and ask prices is sure to attract the largest order flows, which keeps the spread narrower than it would otherwise be.
On the flip side, stocks that are not liquid will almost always have wider spreads. This is due to the fact that it takes longer to make the spread on low volume, and because a larger buy or sell order can have a substantial impact on the price of thinly traded securities. As a result, the market maker is subject to a higher risk of sudden price fluctuations.
Studies have shown that (percentage-wise) cheaper securities tend to have wider spreads. Stocks with lower prices are mostly from small to mid-cap companies, and tend to not be traded as frequently as large-cap securities. Therefore, cheaper stocks are, by their own nature, traded thinly. The market maker will typically ask a larger premium for trading cheaper stocks due to their relative level of liquidity.