Financial Literacy – the basics
In this series of posts I am going to cover some of the basics of financial literacy. While basic, its also critical to understand, as it forms the basis of all things personal finance. If you have a good understanding of these concepts, then you will know more than 99% of people working in financial services companies. Ok, that was a slight embellishment, but you’ll know a lot.
These posts will cover 4 topics:
- Discounted cashflow / present value
These concepts apply to all things finance, not just financial markets. For example, say you’re in the market for a new car. Understanding liquidity (i..e how many of a certain type of car is available) or spread (the difference between the trade-in price and what you’d buy it for) helps you to understand how prices are set.
In the first of these posts, we will cover what is meant by spread.
What is Spread?
The first concept in this series is “spread”. Spread is simply the difference between the price some costs to buy and the amount that it costs to sell. To an investor, spread is a real, economic cost just like commissions or brokerage. It is just often hidden and not easy to understand. As an example, say you’re looking to buy a couple of shares of a Fortune 500 company. You log into your online broker (you know, the one with the cheapest commissions), and look up the price. Its market price is currently $21 per share, so you place an order for 100 shares and wait for it to be executed. Seconds later, you’re matched and the confirmation email hits your inbox. You’re now the proud owner of 100 shares of AAB Inc.
Wait……. AAB Inc? You were after AAC Inc. F%$*&% – a fat finger error.
You quickly check the price and luckily the last sale was $21 per share (which was probably your trade anyway). You immediately put an order in to sell at market and are matched at $20 per share. Its a loss of $1 per share. You’ve just experienced the economic cost of spread. The difference between the buy price and the sale price.
How is spread determined?
Spread is mostly determined by liquidity (the next topic). The more participants there are in any given market and the more there is offered to buy and sell, the ‘tighter’ the spread between the buy and sell price will be. There are two types of market participants, price takers and price makers (or market makers). Do you know which one you are? You should, cause if you don’t you’re getting screwed.
Almost all participants are price takers. Its typically the big banks and funds that are price makers. Think of them as wholesalers. They have the inventory in their warehouse (their balance sheet) and are willing to buy and sell that inventory to any and all. You, as the investor, take the opposite side of the transaction. The two sides are called “bid’ and ‘offer’ (or ask). The person wanting to buy the item makes the ‘bid’ while the person wanting to sell makes the ‘offer’ or ‘ask’. Think asking price.
Two brokers come to the market. Broker A wants to buy stock XYZ while broker B wants to sell stock XYZ. Brokers A is willing to buy at $10 per share, while broker B is willing to sell at $10.50 per share. Now, if neither party change their price, then there will be no transaction. However, broker B suddenly hears a rumour over the wires and decides that if he doesn’t sell NOW, as in right NOW, the price is going to move before everyone else works it out. So he “hits the bid” and is matched at Brokers A price of $10 per share. A transaction is recorded and off it goes to the back office for settlement. Now, if nothing else changes, Broker B has paid the price of $0.50 per share to accept the liquidity offered by Broker A.
How spread impacts your investments
In some markets, such as foreign exchange markets and most equity markets, spreads are very tight. That is, they are very close together because there are lots of buyers and sellers. In order markets, say a private equity deal or real estate, the difference between the two can be very large.
Spread also impacts the amount you pay for managed funds. Whenever you buy a unit in an listed fund, there will be an amount of spread built into the price. For many fund managers, this is how they make a living when the fees they charge are cut to the bone. Ever wondered how funds like Vanguard make money off tracker funds when they charge nil or nearly nil fees? One way is by making money off the spread.
How traders view spread
The image shows a Depth of Market (DOM) screen. This is one tool traders to to place orders in the market. It also demonstrates the concept of spread. The grey column in the middle is the price of the relevant instrument. The blue column shows the various prices traders offer to sell at. You, as the retail trader, take the other side of that when you buy. Thus, if you want to sell 10 shares of the below, you can do so at the offered price of 1192.85 (the DOM doesn’t show the “.” when it adds cents), as there are 104 available at that price. If you wanted to buy, then luckily there are 10 available at the price of 1192.90. The spread between the two price is 0.05, which is the economic cost.
AS you can see spread impacts the amount you pay for an investment. Its important to under what that cost is, as it directly impacts your returns. Every time you buy and sell an investment, you have to make enough to cover the cost of the spread, plus other more observable prices such as commissions and taxes. The more frequently you trade, the most ‘cost’ there is.