Relative spread

What Is Relative Spread?

Relative spread is a metric within the field of market microstructure that measures the difference between the ask price (the lowest price a seller is willing to accept) and the bid price (the highest price a buyer is willing to pay) of a security, expressed as a percentage of the midpoint or ask price. It quantifies the cost of immediately executing a trade and is a key indicator of market liquidity. A narrower relative spread generally signifies a more liquid market, where assets can be bought and sold quickly without significantly impacting their price. This concept is fundamental to understanding transaction costs and the efficiency of various financial markets.

History and Origin

The concept of bid-ask spreads, from which relative spread is derived, has been a central element of financial markets since their inception. Historically, market makers or specialists facilitated trading by quoting distinct buy and sell prices, earning their compensation from the difference. As financial markets evolved, particularly with the advent of electronic trading and increased data transparency, the analysis of these spreads became more sophisticated. Academic research in market microstructure, a branch of financial economics, has extensively studied the determinants and implications of bid-ask spreads. Early models, like those proposed by Demsetz in 1968, explored the role of spreads as compensation for liquidity provision, while later models, such as those by Glosten and Milgrom (1985), incorporated information asymmetry.¹⁹, ²⁰, ²¹ The focus on relative spread gained prominence as a way to standardize comparisons across securities with vastly different price levels, making it a valuable tool in assessing market efficiency and liquidity across diverse asset classes. The ongoing emphasis by regulatory bodies like the SEC on market data transparency further underscores the importance of such measures.¹⁵, ¹⁶, ¹⁷, ¹⁸

Key Takeaways

• Relative spread measures the difference between a security's bid and ask prices as a percentage, indicating trading cost and market liquidity.
• A lower relative spread suggests a highly liquid market with efficient price discovery.
• It is a crucial metric in market microstructure analysis.
• The relative spread can vary significantly based on asset class, trading volume, and market conditions.
• Understanding relative spread helps market participants assess the real cost of executing trades.

Formula and Calculation

The relative spread can be calculated using the following formula:

Alternatively, it can be expressed as:

Where:

• Ask Price: The lowest price at which a seller is willing to sell a security.
• Bid Price: The highest price at which a buyer is willing to buy a security.
• Midpoint Price: The average of the ask and bid prices, calculated as ((\text{Ask Price} + \text{Bid Price}) / 2).

This formula effectively normalizes the spread, making it comparable across securities with different price points. For instance, a small absolute spread on a high-priced stock might be less significant than the same absolute spread on a low-priced stock when viewed in relative terms. This normalization helps in evaluating market efficiency across diverse instruments.

Interpreting the Relative Spread

Interpreting the relative spread involves understanding what the calculated percentage implies about the market for a particular security. A small relative spread, typically less than 0.1%, indicates high market liquidity and low transaction costs. This is common for actively traded, highly liquid assets like major exchange-traded funds (ETFs) or large-cap stocks. Such narrow spreads suggest that there is strong competition among market makers and a high volume of buyers and sellers, allowing trades to be executed quickly and efficiently with minimal price impact.¹², ¹³, ¹⁴

Conversely, a large relative spread (e.g., 1% or more) points to lower liquidity and higher transaction costs. This is often observed in less frequently traded securities, such as small-cap stocks, certain bonds, or thinly traded options. A wider relative spread suggests fewer buyers and sellers, greater information asymmetry among market participants, or higher inventory holding costs for market makers.¹⁰, ¹¹ Investors trading assets with wide relative spreads may face higher costs when entering or exiting positions, potentially eroding their returns.

Hypothetical Example

Consider two hypothetical stocks, Stock A and Stock B, with their respective bid and ask prices:

Stock A:

• Bid Price = $100.00
• Ask Price = $100.05

Stock B:

• Bid Price = $5.00
• Ask Price = $5.02

Let's calculate the relative spread for each:

For Stock A:

• Midpoint Price = (($100.00 + $100.05) / 2 = $100.025)
• Relative Spread = (($100.05 - $100.00) / $100.025 \times 100% = 0.05 / 100.025 \times 100% \approx 0.05%)

For Stock B:

• Midpoint Price = (($5.00 + $5.02) / 2 = $5.01)
• Relative Spread = (($5.02 - $5.00) / $5.01 \times 100% = 0.02 / 5.01 \times 100% \approx 0.40%)

In this example, while Stock A has a larger absolute spread ($0.05) than Stock B ($0.02), its relative spread (0.05%) is significantly smaller than Stock B's (0.40%). This indicates that Stock A is considerably more liquid, and the cost of trading it, as a percentage of its price, is much lower. This highlights why relative spread is a more effective measure for comparing liquidity across securities with different price levels and is a key consideration for algorithmic trading strategies seeking to minimize execution costs.

Practical Applications

The relative spread is a vital metric with numerous practical applications across various financial domains. In investing, it helps traders and investors assess the immediate cost of executing a trade, influencing decisions on order types (e.g., market orders versus limit orders) and the overall profitability of high-frequency trading strategies. For portfolio managers, understanding the relative spread of underlying assets can inform portfolio construction and rebalancing decisions, especially for large positions that could impact prices.

In market analysis, a widening relative spread across an entire market or specific sector can signal deteriorating liquidity conditions, increased market risk, or heightened volatility. Conversely, narrowing spreads often indicate improving market confidence and stability. The Federal Reserve, for instance, monitors various measures of bid-ask spreads, including those in the Treasury market, as indicators of overall market liquidity and financial stability.⁸, ⁹ Regulators also utilize spread data to monitor market fairness and efficiency, ensuring that trading costs are reasonable and that no single entity is unduly influencing prices. The SEC, for example, has continuously emphasized data transparency to ensure fair and efficient markets.⁶, ⁷

Limitations and Criticisms

While a valuable measure, the relative spread has certain limitations and criticisms. One primary critique is that it represents only one dimension of market quality. While a narrow relative spread indicates low explicit transaction costs, it doesn't fully capture other factors such as market depth (the quantity of orders available at different price levels) or price impact (how a large trade moves the market). A security might have a narrow relative spread but limited depth, meaning a large order could still significantly move the price, incurring substantial implicit costs not reflected in the spread alone.⁵

Furthermore, the relative spread can be influenced by factors unrelated to true liquidity, such as scheduled macroeconomic announcements or sudden, unexpected news events. During periods of high uncertainty or stress, spreads can widen dramatically as market makers pull back quotes or widen their margins to account for increased risk, even if underlying trading interest remains. This volatility can make real-time interpretation challenging. Critics also point out that relying solely on relative spread may not provide a complete picture of market efficiency, especially in fragmented markets where liquidity is spread across multiple trading venues. For instance, in the bond market, yield spreads are often analyzed alongside other metrics to gauge credit risk and market sentiment.², ³, ⁴

Relative Spread vs. Absolute Spread

The terms relative spread and absolute spread both refer to the difference between the bid and ask prices of a financial instrument, but they differ in how that difference is expressed.

Confusion often arises because both metrics measure the same underlying phenomenon: the cost of immediacy in trading. However, the relative spread normalizes this cost, making it a more universal indicator for comparing instruments like stocks, bonds, or options that trade at vastly different price points. An absolute spread of $0.10 might be considered negligible for a $1,000 stock but very significant for a $5 stock. The relative spread accounts for this by showing the cost as a proportion of the asset's value, providing a more insightful comparison of their true liquidity and efficiency.

FAQs

What does a high relative spread indicate?

A high relative spread indicates lower market liquidity and higher transaction costs. It suggests that there's a wider gap between what buyers are willing to pay and sellers are willing to accept, often due to fewer market participants, higher perceived risk, or information asymmetry. This can lead to greater price volatility and makes it more expensive to enter or exit positions.

Is a low relative spread always good?

Generally, a low relative spread is considered good as it signifies high liquidity and low transaction costs, making it easier and cheaper to trade a security. However, an extremely low relative spread in certain illiquid markets could sometimes be misleading if there is also very limited market depth, meaning even small orders could move the price significantly.

How does trading volume affect relative spread?

High trading volume typically correlates with a lower relative spread. Increased trading activity attracts more buyers and sellers, leading to greater competition among market makers and a more continuous flow of orders. This enhanced order flow generally results in narrower bid-ask spreads and, consequently, lower relative spreads, reflecting a more efficient market.

Can relative spread change rapidly?

Yes, relative spread can change rapidly, especially in response to significant market news, economic announcements, or sudden shifts in investor sentiment. During periods of heightened uncertainty or market stress, relative spreads tend to widen as market makers become more cautious and demand greater compensation for providing liquidity. Conversely, they can narrow quickly during periods of calm and high trading activity.¹

How does relative spread relate to market making?

Relative spread is central to market making. Market makers profit from the bid-ask spread by buying at the bid price and selling at the ask price. The relative spread reflects the compensation they receive for providing liquidity and assuming inventory risk. A wider relative spread allows market makers higher potential profits but also indicates higher perceived risk or lower competition, while a narrow relative spread indicates competitive pricing and high liquidity.