Definition of Spread
The term ‘spread’ encompasses several distinct financial concepts, each applicable in different contexts. Here are three primary definitions:
- Difference Between Buying and Selling Prices: In financial markets, especially in the context of a market maker, a spread refers to the difference between the price at which an asset is bought (bid price) and the price at which it is sold (ask price).
- Portfolio Diversity: Within the realm of portfolio management, a spread signifies the range and variety of investments within a portfolio. A greater spread within a portfolio generally reduces its volatility.
- Commodity Futures Strategy: In commodities trading, spread refers to the simultaneous purchase and sale of commodity futures. This strategy aims to profit from changes in the relative prices of the commodities or the same commodity across different delivery dates or exchanges.
Examples
- Bid-Ask Spread: Suppose a stock is quoted at a bid price of $50 and an ask price of $52. The spread in this case is $2. Market makers and brokers often earn their profits through this spread.
- Diversified Portfolio Spread: A mutual fund portfolio might include an assortment of stocks, bonds, commodities, and real estate. A broad spread across these asset classes can help in mitigating risk.
- Calendar Spread: An options trader might enter into a calendar spread by purchasing a December Gold futures contract while simultaneously selling a June Gold futures contract, hoping to profit from the difference in their relative prices over time.
Frequently Asked Questions
What is a market maker?
A market maker is a firm or individual that actively quotes two-sided markets in a particular security, providing bid and ask prices along with the market size of each.
How does the spread affect liquidity?
A narrower spread typically indicates higher liquidity, as it suggests that the asset can be easily bought or sold with minimal price impact. Conversely, a wider spread means the asset is less liquid.
Why is portfolio diversity referred to as a spread?
Portfolio diversity, often termed as spread, indicates the variety of different asset types held within a portfolio. This spread helps in risk mitigation by reducing the impact of poor performance of any single investment.
What are the risks involved in commodity futures spread trading?
Commodity futures spread trading involves various risks including market risk, liquidity risk, and execution risk. The trader must prudently manage these risks to achieve desired profits.
Related Terms
- Market Maker: An entity that provides liquidity to the market by quoting buy and sell prices and ready to execute at those prices.
- Portfolio: A collection of different investments held by an individual or an institution.
- Futures Contract: A standardized legal agreement to buy or sell something at a predetermined price at a specified time in the future.
Further Reading and References
Online Resources
Suggested Books
- “Options, Futures, and Other Derivatives” by John C. Hull
- “A Random Walk Down Wall Street” by Burton G. Malkiel
- “Investments” by Zvi Bodie, Alex Kane, and Alan J. Marcus
Accounting Basics: “Spread” Fundamentals Quiz
### What is the primary characteristic of a spread in the context of a market maker?
- [ ] The total stock price.
- [ ] Quarterly earnings reports.
- [x] The difference between bid and ask prices.
- [ ] Dividend yield of a stock.
> **Explanation:** The spread in a market maker's context is primarily the difference between the bid price (buying price) and the ask price (selling price). This is how market makers earn their profit through facilitating trades.
### What can a greater diversity of investments in a portfolio indicate?
- [ ] Higher volatility.
- [x] Lower volatility.
- [ ] Higher market risk.
- [ ] Increased single-asset dependency.
> **Explanation:** Greater diversity in a portfolio (a greater spread) typically reduces volatility by spreading risk across multiple assets, minimizing the impact of any single asset's poor performance.
### In commodities trading, what does a spread strategy involve?
- [x] Simultaneously buying and selling commodity futures.
- [ ] Only buying futures.
- [ ] Only selling futures.
- [ ] Purchasing options contracts.
> **Explanation:** A spread strategy in commodities trading involves the simultaneous purchase and sale of commodity futures, aiming to profit from changes in relative prices.
### Which of the following would be considered a calendar spread?
- [ ] Buying and selling the same commodity for the same delivery date.
- [ ] Purchasing physical commodities.
- [x] Buying and selling the same commodity for different delivery dates.
- [ ] Holding an outright commodity position.
> **Explanation:** A calendar spread involves buying and selling the same commodity but with different delivery dates, aiming to benefit from the changes in prices between these two contracts.
### What defines a tight spread in financial markets?
- [ ] A wide gap between trading volumes.
- [x] A small difference between the bid and ask prices.
- [ ] High volatility in asset prices.
- [ ] Low overall market liquidity.
> **Explanation:** A tight spread signifies a small difference between the bid and ask prices, often indicating higher liquidity and lower transaction costs for investors.
### Which entity benefits from a tighter spread in a listed stock?
- [ ] Market regulators.
- [ ] Brokers exclusively.
- [x] Investors and traders.
- [ ] Only the issuing company.
> **Explanation:** Investors and traders benefit from a tighter spread because it generally means lower costs to execute trades and higher liquidity.
### What is a key benefit of a diversified portfolio spread?
- [ ] Higher guaranteed returns.
- [ ] Predictable cash flows.
- [x] Reduced investment risk.
- [ ] Increased transaction fees.
> **Explanation:** The key benefit of a diversified portfolio spread is reduced investment risk. By spreading investments across various asset types, the negative impact of any single investment is minimized.
### How is a variation spread typically viewed in trading?
- [ ] As an indicator of monetary policy.
- [x] As a means of hedging risk.
- [ ] As a social investment measure.
- [ ] As a form of tax avoidance.
> **Explanation:** In trading, a spread strategy, such as a variation spread, is used to hedge risk by capitalizing on price discrepancies between two related futures contracts.
### What is the effective use of a bid-ask spread for a retail trader?
- [ ] To avoid paying dividends.
- [x] To gauge transaction costs.
- [ ] For income tax calculations.
- [ ] For retirement asset estimation.
> **Explanation:** Retail traders use the bid-ask spread to gauge transaction costs. A narrow spread means lower costs to enter or exit positions.
### Which term best describes the simultaneous purchase and sale of spread positions in commodity futures?
- [ ] Ladder trading.
- [ ] Algorithmic trading.
- [x] Spread trading.
- [ ] Margin trading.
> **Explanation:** Spread trading accurately describes the practice of simultaneously purchasing and selling futures contracts to profit from price differences.
Embrace your journey through intricate financial concepts, and continue striving towards mastering the depth of accounting knowledge. Happy studying!
