What is the spread?

What is spread?

At first glance, the word “spread” might bring to mind a sandwich filling — but in the financial world, it has a far more strategic meaning. The term “spread” refers to the difference between the bid price and the ask price of a financial instrument — whether it’s a stock, commodity, currency pair or bond. This seemingly small gap can have a big impact on trading outcomes and costs. Understanding how spreads work is essential for any trader or investor. It’s not just a pricing detail — it’s a key metric of market liquidity and trading efficiency.

What is spread in finance?

The concept of spread is used broadly in financial markets, though its specific application varies depending on the asset class.

• In stock trading, a spread is the difference between the buying (bid) and selling (ask) prices quoted for a particular share.
• In futures markets, it can reflect the price difference between contracts for the same commodity but with different delivery dates.
• In bond markets, spreads often indicate differences in yields between securities of varying credit quality or maturity.

Each market interprets spreads through its own lens — but the core idea remains consistent: it’s a measure of the gap between supply and demand.

Key takeaways

• A spread is the difference between the bid price (the highest price a buyer is willing to pay) and the ask price (the lowest price a seller is willing to accept).
• Spreads are found in all types of financial markets — including equities, bonds, commodities, forex, and even betting or gaming contexts.
• In bond trading, a spread often means the difference in yield between two similar bonds with different risk profiles or maturities.
• Traders monitor spreads to assess market conditions, trading costs, and liquidity levels.

Understanding spreads

Spreads can serve as a barometer for the overall health of a market. A wide spread might signal low liquidity or heightened volatility, while a tight spread suggests active trading and strong market depth.

Interestingly, the word “spreadsheet” originated from financial recordkeeping — a literal sheet where spreads, or differences, between values were calculated.

In everyday finance, people unknowingly deal with spreads all the time — such as the gap between monthly income and expenses. In financial trading, the stakes are higher, and understanding spreads is critical for decision-making.

Spread meaning across asset classes:

• In stocks: Spread reflects the difference between the prices a trader is willing to pay (bid) and accept (ask).
• In forex: Spreads are extremely tight due to high liquidity — often just fractions of a cent.
• In bonds: It typically refers to differences in yield rather than price.
• In futures contracts: It shows the pricing difference between two contracts for the same commodity, but different delivery months.

For example, if a January wheat futures contract trades at $700 and the October contract at $680, the spread is $20 — and this gap may widen or narrow based on market sentiment, supply dynamics, or macroeconomic factors.

Types of spreads

The bid-ask spread

One of the most commonly referenced spreads in trading is the bid-ask spread — sometimes called the bid-offer or buy-sell spread. It shows the immediate cost of executing a trade at market prices.

Example: If a stock has an ask price of £12 and a bid price of £10.50, the spread is £1.50.

This spread is a crucial measure of liquidity. Assets with high liquidity, like major currency pairs, tend to have very narrow spreads. In contrast, thinly traded assets or small-cap stocks might display wider spreads, reflecting limited market participation.

Spread trades

A spread trade — also known as a relative value trade — involves the simultaneous buying and selling of two related financial instruments. These instruments are paired together in a single trade, and each side of the trade is known as a "leg."

The goal is to profit from changes in the price difference (the spread) between the two instruments, rather than from the absolute movement of either one.

Why execute spread trades as a unit?

• Synchronized execution: It helps ensure that both legs are executed simultaneously, avoiding partial fills.
• Reduced execution risk: The risk of one leg executing while the other fails is minimized.
• Focused exposure: Traders can isolate spread movements rather than being exposed to price swings of individual assets.

Spread trading is common in futures and options markets, where the instruments are closely related in structure and pricing.

Main types of spread trades:

• Calendar spreads: These trades involve contracts on the same asset but with different expiration dates. A trader might, for instance, go long on January crude oil futures while simultaneously shorting October contracts.
• Intercommodity spreads: These involve different but related commodities — for example, trading the historical price relationship between gold and silver.
• Option spreads: These strategies are based on buying and selling options on the same underlying asset, but with different strike prices or expiration dates.

Spread trading can serve both speculative and hedging purposes. In some cases, a relatively small margin requirement can provide exposure to spread fluctuations — but this leverage also amplifies risk, which must be carefully managed.

Yield spread

The yield spread — sometimes referred to as the credit spread — represents the difference in yield between two different fixed-income securities. It’s commonly used as a measure of relative risk between those instruments.

For example, if a U.S. Treasury bond yields 4% and a corporate bond yields 6%, the yield spread is 2%. This spread reflects the additional compensation investors demand for taking on higher credit risk.

Analysts often express this as:
 “The corporate bond yields 200 basis points over Treasuries.”

Yield spreads help market participants evaluate macroeconomic conditions, credit risk, and interest rate expectations.

Option-adjusted spread (OAS)

To account for the impact of embedded options (such as early repayment features in mortgage-backed securities), analysts adjust yield spreads using models.

The result is called the option-adjusted spread (OAS) — a measure that isolates pure credit and liquidity risk from option-related volatility.

OAS is used for pricing:

• Callable bonds
• Mortgage-backed securities (MBS)
• Interest rate derivatives

By comparing OAS to benchmark yield curves, investors assess whether a security is fairly valued relative to others with similar profiles.

Z-spread

The Z-spread, also known as the zero-volatility spread or yield curve spread, takes the present value of a bond’s cash flows — discounted using spot rates from the Treasury yield curve — and determines the constant spread that must be added to match the bond’s market price.

Z-spreads are particularly useful for analyzing mortgage-backed or asset-backed securities, where cash flow timing is uncertain.

Credit spread

The credit spread refers to the difference in yield between a risk-free government bond and another bond with the same maturity but a different credit rating.

For example:

• 10-year U.S. Treasury: 4.0% yield
• 10-year corporate bond: 6.0% yield → Credit spread = 2.0% (or 200 basis points)

The term is also used in options strategies where a trader buys and sells options on the same asset to capture premium differences — often aiming to generate income or hedge directional risk.

Strategies for managing spread costs

Spreads represent an implicit cost of trading. To mitigate their impact, traders may apply the following strategies:

• Balance trades: Entering offsetting positions can reduce the effect of spread fluctuations.
• Limit orders: Instead of using market orders, limit orders allow traders to set acceptable entry/exit prices — often within tighter spreads.
• Broker comparison: Choosing a broker with consistently narrow spreads can directly reduce trading expenses.
• Low-cost trading platforms: Many modern platforms offer reduced spreads or commission-free trading, which can benefit active traders.
• Low leverage: Trading with lower leverage means spread-related losses are proportionally smaller. High leverage magnifies every cost, including spreads.

Minimizing spread costs is especially crucial in high-frequency strategies, where even tiny differences add up over many trades.

Advantages of trading spreads

Spread trading offers several benefits compared to traditional directional trades. While it still involves market risk, many traders use spread strategies to balance exposure and control costs more effectively.

Key advantages:

• Risk reduction: By taking positions in two related instruments, traders can hedge some of the market volatility. For example, if one leg of the trade loses value, the other may gain — offsetting the loss.
• Cost efficiency: Spread trades often come with lower transaction costs and margin requirements. In some cases, brokers offer favorable margin treatment for spreads due to the reduced directional risk.
• Leverage potential: Since spreads can require less capital, they may allow for greater exposure with a smaller initial outlay. However, it's crucial to remember that leverage can amplify losses just as easily as gains.
• Improved price discovery: Spread trading contributes to market efficiency by narrowing price differences and providing liquidity between related instruments.
• Lower volatility exposure: Since the trade is based on relative performance, it is generally less sensitive to broad market movements — making it appealing in choppy or uncertain environments.

Despite these advantages, spread trading is not risk-free. Misjudging the relationship between the instruments, unexpected market events, or execution issues can still result in losses.

Popular spread trading strategies

Professional and retail traders alike use a range of spread strategies to exploit market inefficiencies or hedge portfolio positions. Some of the most widely used include:

1. Momentum spread trading

This strategy involves trading instruments with differing momentum signals. For example, a trader may go long on a futures contract trending strongly upward, while shorting a similar asset showing weakness. The goal is to profit from the divergence in performance between the two instruments.

2. Pairs trading

Pairs trading involves identifying two historically correlated assets and taking opposing positions when that correlation breaks. For instance, if Stock A and Stock B typically move together, but A rises sharply while B lags, a trader might short A and go long on B — expecting the spread to revert. This is a classic market-neutral strategy, often used in equities.

3. Arbitrage trading

Arbitrage strategies aim to exploit price discrepancies across markets. In a basic inter-exchange arbitrage, a trader buys an asset in one market while simultaneously selling it in another where the price is higher — profiting from the spread.

Though these opportunities are typically small and short-lived, they can be highly efficient when executed at scale with automation.

4. Reversal spread trading

Reversal strategies involve betting on a change in trend. A trader might short the outperforming leg and go long the underperforming one — anticipating a reversal in their relative valuations.

This can be high-risk and requires solid timing and market insight.

5. Trend-following spread trading

In this approach, both legs are aligned with the prevailing trend — but with different instruments. For instance, buying a stronger commodity while shorting a weaker correlated one. It’s a way to leverage relative strength while staying within a broader directional framework.

Spread risks

While spread trading offers strategic advantages, it also introduces specific types of risk that traders must account for. The challenge lies not only in predicting the direction of each leg, but in forecasting how the relationship between the two instruments will behave.

Below are the main categories of risks associated with spread-based strategies:

1. Spread risk

This is the fundamental risk that the spread between the two instruments moves contrary to expectations. Even if both legs perform as anticipated in isolation, a relative misalignment can lead to a loss.

Example: A trader expects the yield difference between a corporate bond and a Treasury bond to narrow, but it widens instead — resulting in a negative return.

2. Basis risk

Basis risk occurs when the two instruments used in a spread do not move in perfect correlation, despite appearing related. This is especially common in intercommodity or calendar spreads, where external variables affect each asset differently.

3. Yield curve risk

For bond spreads, shifts in the shape of the yield curve — such as steepening or flattening — can distort expectations. A position that benefits from stable curve dynamics may suffer if macroeconomic conditions change rapidly.

4. Liquidity risk

Less liquid markets can cause slippage or wider-than-expected spreads, especially during volatile periods or off-peak trading hours. When one leg is executed and the other fails or lags, the position becomes vulnerable to market moves.

This is particularly relevant for small-cap equities or thinly traded futures contracts.

5. Counterparty risk

For spread trades executed via OTC instruments (such as certain options or credit derivatives), there is a risk that the counterparty may default or fail to honor the agreement. Even in exchange-traded products, settlement risks exist.

6. Currency risk

In cross-border spread trades, fluctuations in exchange rates can distort the intended price relationship. For example, if a trader holds two bonds denominated in different currencies, unexpected FX movements can influence the yield spread.

7. Political and regulatory risk

Changes in government policy or unexpected regulation can create distortions in specific market segments. This is especially relevant in emerging markets, commodity-linked trades, or sectors exposed to fiscal reform.

8. Market risk

Finally, broad market conditions — such as economic shocks, inflation surprises, or central bank announcements — can trigger unpredictable shifts in spread behavior, even among traditionally stable pairs.

FAQ