Spread in finance encompasses various meanings, generally denoting the disparity or gap between two prices, rates, or yields. 

One prevalent definition pertains to the difference between the bid and ask prices of a security, such as a stock, bond, or commodity—referred to as a bid-ask spread. 

Additionally, spreads can be established in financial markets involving multiple bonds, stocks, or derivatives contracts. This broad term captures the diverse ways in which discrepancies manifest in financial instruments.

Understanding Spreads

Spreads can also denote the disparity in a trading position – the difference between initiating a short position (selling) in one futures contract or currency and initiating a long position (buying) in another. This practice is officially recognized as a spread trade.

In underwriting, the spread may signify the variance between the amount disbursed to the issuer of a security and the price paid by the investor for that security – specifically, the underwriter's cost to purchase an issue compared to the price at which it is sold to the public.

Regarding lending, the spread may additionally allude to the cost a borrower incurs above a benchmark yield to secure a loan. For instance, if the prime interest rate is 3%, and a borrower secures a mortgage at a 5% rate, the spread amounts to 2%.

The spread trade is also known as the relative value trade. Spread trades involve the simultaneous purchase of one security and the sale of another related security as a unit. Typically, these trades involve options or futures contracts and are executed to yield an overall net trade with a positive value, referred to as the spread.

Types of Spreads

Many financial markets have spreads, which change based on the kind of financial instrument or security being traded.

In many securities with a two-sided market, such as stocks, a bid-ask spread is present, representing the difference between the highest bid price and the lowest offer. This spread serves as an indicator of a stock's liquidity.

Forex trading also involves bid-ask spreads, which can vary based on factors like the liquidity of the currency pair, market conditions, and the broker's pricing policies. Brokers may apply fixed spreads or variable spreads that fluctuate with market conditions. 

Traders need to comprehend the quoted spreads, as they can significantly influence the overall cost of a trade. Understanding these spreads is crucial for effective decision-making in the trading process.

Interest Rate Spreads

A yield spread refers to the variation in yields between different debt instruments, taking into account factors such as maturity, credit ratings, issuer, or risk level. It is typically calculated by subtracting the yield of one instrument from another, commonly expressed in basis points (bps) or percentage points. When compared to U.S. Treasuries, it is termed as the credit spread. 

Analysts often denote it as the “yield spread of X over Y,” representing the annual percentage return on investment for one financial instrument minus another.

The option-adjusted spread (OAS) gauges the yield difference between a bond with an embedded option, like a Mortgage-Backed Security (MBS), and Treasuries. This measure is more precise than a simple yield-to-maturity comparison to a benchmark. By analyzing the bond and embedded option separately, analysts can assess the investment's viability at a specific price. 

To align a security's price with the market, the yield spread is added to a benchmark yield curve, yielding the option-adjusted spread. This is commonly employed for MBS, bonds, interest rate derivatives, and options. For securities with distinct cash flows from future interest rate changes, the OAS aligns with the Z-spread.

The zero-volatility spread (Z-spread) is a constant spread ensuring a security's price equals the present value of its cash flows when added to the yield at each point on the spot rate Treasury curve where cash flow is received. It aids investors in determining the bond's current value and cash flows at these points. Analysts and investors utilize the Z-spread to identify pricing disparities in bonds. 

Also known as the yield curve spread, it is applicable in mortgage-backed securities, relying on zero-coupon treasury yield curves for discounting cash flows to attain the current market price. This spread is also employed in credit default swaps (CDS) to gauge credit spread.

Options Spreads

Call spreads entail simultaneously buying and selling different call options on the same underlying asset. A bullish call spread generates profit with a rising underlying, while a bearish call spread does so with a falling underlying.

Put spreads operate similarly but involve put options instead of calls. Similar to call spreads, there are bullish put spreads and bearish put spreads.

A long butterfly is a strategy with a neutral to bullish outlook, achieved by concurrently purchasing two options with lower strike prices, selling one option with a higher strike price, and selling another option with an even higher strike price. The objective is to capitalize on a narrow range of movement in the underlying asset.

Variations of the butterfly include the condor, iron butterfly, and iron condor.

Calendar spreads involve simultaneously buying an option with a longer-term expiration date and selling an option with a shorter-term expiration date on the same underlying asset. The goal is to profit from the difference in the rate of time decay between the two options.

A box spread, or long box, is an arbitrage strategy that combines buying a bullish call spread with a corresponding bearish put spread. It can be viewed as two vertical spreads, each with the same strike prices and expiration dates, and its value will always be the distance between the strike prices at expiration.

Spread Risks

Spread trading, similar to any other trading method, comes with inherent risks that traders and investors need to acknowledge. One such risk is market risk, which can impact the value of the underlying assets and the overall profitability of a spread trade. 

For instance, if a trader initiates a bull call spread with the anticipation that a particular stock will experience an upward price movement, but unforeseen market conditions cause the stock's price to unexpectedly drop, the trader may incur a loss on the spread trade. 

Similarly, in cases where a trader speculates on a spread narrowing, but it instead widens, financial losses can occur. It is crucial for individuals engaged in spread trading to be mindful of these potential risks.

Conclusion

The difference or gap between two prices, rates, or yields is referred to as a spread in the finance world. The bid-ask spread, or the difference between the asking and bid prices of an asset or security, is one way that the term "spread" is frequently used. The term "spread" can also relate to the difference in a trading position, e.g., the difference between a spread trade, which is the selling position in one futures contract or currency and the buying position in another. 

Disclaimer

Derivative investments involve significant risks that may result in the loss of your invested capital. You are advised to carefully read and study the legality of the company, products, and trading rules before deciding to invest your money. Be responsible and accountable in your trading.

RISK WARNING IN TRADING

Transactions via margin involve leverage mechanisms, have high risks, and may not be suitable for all investors. THERE IS NO GUARANTEE OF PROFIT on your investment, so be cautious of those who promise profits in trading. It's recommended not to use funds if you're not ready to incur losses. Before deciding to trade, make sure you understand the risks involved and also consider your experience.