When trading stocks, there are several market terms that are helpful to understand, such as portfolio, dividend, and volatility. Another key term to know is spread.
In simple terms, a spread represents the difference between any two financial metrics. The type of spread depends on the type of security that’s being traded. For example, when trading bonds, the spread can refer to a difference in yields between bonds of varying maturity lengths or quality.
But there are many differences between bonds vs. stocks—and spread is one of them. With stocks, spread refers to differences in price. Specifically, it measures the gap between the bid price and the ask price. Understanding what is spread and how it works can help you more effectively shape your investment strategy.
What Is Spread?
Spread is the difference between two financial measurements. When talking specifically about a stock spread, it is the difference between the bid price and the ask price.
The bid price is the highest price a buyer will pay to purchase one or more shares of a specific stock. The ask price is the lowest price at which a seller will agree to sell shares of that stock. The spread represents the difference between the bid price and the ask price.
A good way to visualize spread may be to think of buying a home. As a home buyer, you may have a set price that you’re willing to pay for a property, based on what you can afford and what you’ve been pre-approved for by your mortgage lender.
You search for homes and eventually find one that has everything on your wishlist. When you check the listing price, you see that the seller has it priced $10,000 above your budget. In terms of spread, the maximum amount you’re willing to offer for the home represents the bid price, while the seller’s listing price represents the ask.
What Does Spread Mean?
Aside from stock spread, spread can have a variety of applications and meanings in the financial world.
As mentioned earlier, bond spread typically refers to differences in yield. But if you’re trading futures, the spread can measure the gap between buy and sell positions for a particular commodity. With options trading, it can refer to differences in strike prices when placing call or put options.
Recommended: A Beginner’s Guide to Options Spreads
Spread can also be used in foreign currency markets or forex (foreign exchange market) trades to represent the difference between the costs for traders and the profits realized by dealers.
With lending, spread is tied to a difference in interest rates. Specifically, it means the difference between a benchmark rate, such as the prime rate, and the rate that’s actually charged to a borrower. So for example, if you’re getting a mortgage there might be a 2% spread, meaning your rate is 2% higher than the benchmark rate.
Bid-Ask Price and Stocks Spread
If you trade stocks online, it’s important to understand how the bid-ask price spread works and how it can affect your investment outcomes. Since spread can help gauge supply and demand for a particular stock, investors can use that information to make informed decisions about trades and increase the odds of getting the best possible price.
Normally, a stock’s ask price is higher than the bid price. How far apart the ask price and bid price are can give you a sense of how the market views a particular security’s worth.
If the bid price and ask price are fairly close together, that suggests that buyers and sellers are more or less in agreement on what a stock is worth. On the other hand, if there’s a wider spread between the bid and ask price, that might signal that buyers and sellers don’t necessarily agree on a stock’s value.
What Influences Stock Spreads?
There are different factors that can affect a stock’s spread, including:
• Supply and demand. Spread can be impacted by the total number of outstanding shares of a particular stock and the amount of interest investors show in that stock.
• Liquidity. Generally, liquidity is a measure of how easily a stock or any other security can be bought and sold or converted to cash. The more liquid an investment is, the closer the bid and ask price may be, since it can be easier to gauge an asset’s worth.
• Trading volume. Trading volume means how many shares of a stock or security are traded on a given day. As with liquidity, the more trading volume a security has, the closer together the bid and ask price are likely to be.
• Volatility. Volatility is a way of gauging price changes and how rapidly a stock’s price moves up or down. When there are wider swings in a stock’s price, i.e. more volatility, the bid-ask price spread can also be wider.
When you understand how spread works for stocks, you can use that to invest strategically and manage the potential for risk. This means different things whether you are planning to buy, sell, or hold a stock. If you’re selling stocks, that means getting the best bid price; when you’re buying, it means paying the best ask price. Essentially, the goal is the same as with any other investing strategy: to buy low and sell high.
Executing Stock Trades Using Spread
If you’re using the bid-ask spread to trade stocks, there are different types of stock orders you might place. Those include:
• Market orders. This is an order to buy or sell a security that’s executed immediately.
• Limit orders. This is an order to buy or sell a security at a certain price or better.
• Stop orders. A stop order, also called a stop-loss order, is an order to buy or sell a security once it hits a certain price. This is called the stop price and once that price is reached, the order is executed.
• Buy stop orders. Buy stop orders are used to execute buy orders only when the market reaches a certain stop price.
• Sell stop orders. A sell stop order is the opposite of a buy stop order. Sell stop orders are executed when the stop price falls below the current market price of a security.
Stop orders can help with limiting losses in your investment portfolio if you’re trading based on bid-ask price spreads. Knowing how to coordinate various types of orders together with stock spreads can help with getting the best possible price as you make trades.
The Takeaway
The more investing terms an investor is familiar with, the better able they’ll be to invest with confidence. Spread is a term that means different things in different situations, but when it comes to stocks, spread is the difference between the bid price and ask price of a given stock. Being able to assess what a spread might mean can help inform individual trading decisions.
As you learn more about stocks, including what is spread and how it works, you can use that knowledge to create a portfolio that reflects your financial needs and goals.
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