Spread

Spread denotes the ability of an investor to trade in the market by being able to request to sell or buy financial assets/commodities at ask or bid prices, respectively. The difference between ask and bid prices is called spread and reflects liquidity available in the market. The larger the spread, the less willingness there is to trade in the respective asset. An alternative definition of the spread is related to the strategy that involves the simultaneous use of two or more options of the same type. These option positions are taken to profit from short-term movements. However, profits can be made even if the stock price does not diverge from a specific exercise price.

Market makers are in charge of supporting liquidity in the market. As a reward, they can purchase assets at the bid price and sell them at the offer prices. Before the reduction of the tick size, that is, the minimal price increase, from one-sixteenth of a dollar to one cent in 2001 at the New York Stock Exchange (NYSE), this strategy could have provided the market maker with significant profits. Specialists at NYSE also post bid and ask depth, which is determined by the volume of securities offered and requested at various ask and bid prices. The lower the difference between prices and the larger the volumes offered at each price, the greater the depth. The existence of the bid and ask price does not indicate that transactions are exclusively executed at these prices. Bid price is requested by the potential buyer, while the initial offer of the seller is summarized in the offer/ask price. The executed price may be bid, ask, or any other value within a spread. The swings from bid to ask prices and vice versa can lead to noticeable market movements, which was explained as part of a so-called January effect. Selling at a bid price in a seller-initiated trade in December will depress prices compared to an enthusiastic purchase spree at the ask price initiated by a buyer in January.

Albeit rather simple to define, the spread in itself has a challenging structure. Apart from the coverage of the already explained order processing cost for market makers, the spread contains the adverse selection component that reflects the attitude of an uninformed investor faced with informed counterparts. The spread will increase in the state of increased information asymmetry and vice versa. Finally, the third component is determined by the market maker's decision to change quotes in an attempt to hedge inventories as a response to the behavior of other market participants. To evaluate these elements, it is necessary to introduce the notion of a trade spread in which all trades higher than the spread midpoint are buyer initiated and all prices below the spread midpoint are seller initiated.

There are at least four spread trading strategies in the derivatives markets: bull, bear, butterfly, and calendar. In the bull spread, an investor intends to profit from an increase in the price of an underlying asset. The call option with the lower exercise price is purchased, while the second call option with a higher exercise price is sold. The initial loss due to the higher premium paid than received can be reversed if the price of the underlying asset reaches the higher exercise price.

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