How to Calculate Spread

By Motley Fool

The word "spread" has several different meanings in investing, and can apply to stocks, bonds, or options. Here's a rundown of the various uses of the term, and how each type of spread can be calculated.

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Bid-ask spreadWhen you check a stock quote, in addition to the last trade price, you'll see two other prices known as the "bid" and the "ask." The bid price represents the highest price someone is currently willing to pay for the stock, while the ask price represents the lowest price someone is willing to sell the stock for.

Simply put, the difference between the two prices is known as the spread.

In general, larger companies whose stocks have high volumes tend to have low spreads sometimes just a penny or two. On the other hand, stocks of smaller companies with relatively low volume may high much higher spreads.

Yield spreadThe word "spread" is also used when talking about debt securities, such as bonds or CDs. The calculation for a yield spread is essentially the same as for a bid-ask spread simply subtract one yield from the other.

For example, if the market rate for a five-year CD is 5% and the rate for a one-year CD is 2%, the spread is the difference between them, or 3%.

Yield spreads are often expressed in basis points, and a 1% difference in yield is equal to 100 basis points. So, the yield spread between two bonds -- one paying 5% and one paying 4.8% could be stated as either 0.2% or 20 basis points.

Option spreadsWhen talking about options, "spread" has a different meaning entirely. A spread is a type of options trade that involves purchasing one option and selling another of the same stock. There are a few main types of spreads; vertical spreads involve buying and selling options with different strike prices, calendar spreads (also known as horizontal spreads) involve options with different expiration dates, and diagonal spreads involve both different strike prices and expiration dates.

For example, suppose a certain stock is trading for $50. And, let's say that its $45 call options expiring in a certain month are trading for $6.00 per share, while the $50 call options with the same expiration date are trading for $3.50.

A possible vertical spread might involve buying the $45 calls and selling the $50 calls, at a net cost per share of $2.50. There are three scenarios that could happen. The stock could fall to $45 or less at expiration, and the spread would be worth nothing. The stock could remain at $50 or go higher, and the spread would be worth $5.00 -- the maximum possible profit. Or, the stock could finish somewhere between $45 and $50. This trade would be profitable if the underlying stock's price was $47.50 or higher at the time the options expired.

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