Spread Essay ⋆ Business Essay Examples ⋆ EssayEmpire

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.

In the bear spread, an investor expects a price decline and the call option with the higher exercise price is bought, while the one with the lower exercise price is sold. The positive difference between premiums is the major income source in this case. The same strategies can be achieved with put options. In butterfly spreads, the highest profit is realized if the stock price is close to the midway exercise price. Two call options with the highest and lowest exercise prices, respectively, are bought, while two call options are sold at the price that is close to the current market price and midway between the previous two exercise prices.

As in the previous two cases, put options can be used with identical purchase/sale steps involved. Unlike in bull, bear, and butterfly strategies, in the calendar spread there is no assumption about the use of options with identical expiration dates. The sale of a call option and the purchase of a longer-maturity call option with the same strike price lead to profits if the stock price is close to the exercise price when the short-term call option matures.

Bibliography:

Hee-Joon Ahn, The Components of the Bid-Ask Spread in a Limit-Order Market: Evidence From the Tokyo Stock Exchange (Columbia Business School, 2003);
John Y. Campbell, Andrew W. Lo, and Archie Craig MacKinlay, Econometrics of Financial Markets (Princeton University Press, 1997);
Bart Frijns, Aaron Gilbert, and Alireza Tourani-Rad, Insider Trading, Regulation and the Components of the Bid-Ask Spread (Auckland University of Technology, 2005);
Roger D. Huang and Hans R. Stoll, “The Components of the Bid-Ask Spread: A General Approach,” Review of Financial Studies (v.10, 1997);
John C. Hull, Options, Futures and Other Derivatives (Prentice Hall, 2000);
Kenneth A. Kavajecz, “A Specialist’s Quoted Depth and the Limit Order Book,” Journal of Finance (v.54/2, 1999);
Donald B. Keim, “Trading Patterns, BidAsk Spreads, and Estimated Security Returns: The Case of Common Stocks at Calendar Turning Points,” Journal of Financial Economics (v.25/1, 1989);
Naiping Liu and Lu Zhang, “Is the Value Spread a Useful Predictor of Returns?” Journal of Financial Markets (v.11/3, 2008);
Richard Roll, “A Simple Implicit Measure of the Effective Bid-Ask Spread in an Efficient Market,” Journal of Finance (v.39/4, 1984);
Nuttawat Visaltanachoti, Hang Luo, and Jian Tang, Trade Scheduling and Bid-Ask Spread Forecasting: Evidence From the Shenzhen Stock Exchange (Massey University, 2005).

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