Dec
03
2009

What is a financial spread?

About to lose his shirt? (photo by hikingartist.com - CC-BY)

About to lose his shirt? (artwork by hikingartist.com - CC-BY)

A “spread”, in finance, is a pair of prices—one for buying and one for selling. The most common type of financial spread is the bid-offer spread.

The offer price is the price at which a broker or market maker will sell you shares (or some other financial instrument). The bid price is the price at which the broker or market maker will buy those same investments back from you.

The dealer (the broker or market maker) is agnostic to the price of the shares. They don’t care whether they are a good investment or not. That’s because the dealer makes their money not from speculating on the share price, but from the difference between the bid and offer prices—from the spread, in other words.

Over the course of an investment, it’s inevitable that you are going to buy it and sell it. Provided the dealer quotes a lower price for buying (the bid) and a higher price for selling (the offer), they will make money. You, on the other hand, gain the advantage of liquidity: you can buy or sell the investment on the spot according to your whim. The dealer will be buying and selling “across the spread” in the course of their business, and that’s where they make their money. There may also be brokerage fees, in which case the “spread” represents an additional cost for immediate liquidity.

If a dealer wishes to attract business, they will quote a “narrow spread”, with the bid and offer prices close to each other, which provides maximum value to buyers and sellers. Dealing is a competitive business so there will be competition amongst market makers to make their spreads narrow enough to attract customers, yet as wide as they can get away with to maximise their profits.

Suppose you are quoted a bid-offer spread on Acme Widgets Inc of 148 to 152 pence. This means you can buy these shares for 152 pence each, or sell them for 148 pence each. Let’s assume you buy some shares at 152 pence each. Some time later the bid-offer spread is 153 to 155 pence, and you sell your holding. Because you must buy at the offer price and sell at the bid price, you will only have made one penny on each share (the difference between 152 and 153 pence), even though the value of the underlying investments has changed by more than this. In this example, the mid-point of the bid-offer spread rose by 4 pence—from 150 to 154 pence.

Before you can make any money on an investment, its underlying value needs to rise by the amount of the bid-offer spread. But if the value of the investment falls, you lose an amount equal to the sum of the bid-offer spread plus the drop in the underlying value.

In times of uncertainty and rapidly-changing prices, the dealer is likely to quote a very wide spread, to reduce their risk. In times of financial stability, the bid-offer spread might be relatively narrow.

A financial spread can be quoted for any kind of security such as stocks, options, currency swaps, and futures contracts, or for any standardised tradeable commodity such as wheat or coffee beans.

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