How to Calculate Spread

Spread is a concept that many investors use in different ways to evaluate different investment options and their liquidity. Two popular spread calculations are the bid-ask spread of individual stocks and the yield spread of two bonds or similar debt instruments.

For stocks, the bid-ask spread represents the difference between the bid and ask prices at any given point in time. And these two describe the highest amount the investor is willing to spend to buy shares in company stock, and the lowest amount the seller is willing to take for them.

But for bonds and other debt instruments, spread represents the difference in the yield-to-maturity of two different options. In this case, the yield-to-maturity is the best interest rate that an investor could get by buying a bond at market price and holding it until it matures. And it assumes that you will reinvest all dividends, and get paid coupons and principals on time. Learning to calculate spread is a must for stock and bond traders.

Calculate Stock Bid-Ask Spread

To calculate the stock bid-ask spread, first look up the bid price of the stock in question. The bid price represents the price that the most recent interested buyers are willing to pay for a stock at a given time.

You can look up your chosen stock on your preferred stock market news website, such as MarketWatch, or the website of the exchange on which the stock is listed to determine the bid price at a point in time.

Next, look up the ask price of the stock. Look near the listed bid price to find the current ask price – most stock news outlets will list both of these figures side-by-side.

Finally, subtract the bid price from the ask price to calculate the bid-ask spread. For example, if a stock's bid price is currently $15, and the ask price is currently $16, subtracting the ask price from the bid price would result in a spread that would come out to $1.

Calculate Bond-Yield Spread

To calculate the bond-yield spread, write down the annual coupon payment amounts, number of years to maturity, the bond’s par value and purchase prices of both bonds you want to compare.

The annual coupon payment equals the dollar amount received for interest each year, not the interest rate. And you need to subtract the current age of the bond from its total payback period to find the number of years left until maturity. Also, the par value represents the purchase price listed on the bond, and the purchase price variable represents what you actually paid for the bond.

Next, determine the yield-to-maturity (YTM) of both bonds. Plug the variables listed above into a free online YTM calculator to quickly determine the YTM of both options, as the formula is more complex and time-consuming than other investment-related metrics.

If you wish to perform the calculation by hand, use the following formula to solve for YTM for each bond, C (1 + YTM) ^ -1 + C (1 + YTM) ^ -2 + … + C (1 + YTM) ^ - Y + B (1 + YTM) ^ - Y = P, where C = the annual coupon payment, Y = the number of years to maturity, B = the par value/face value and P = the purchase price.

Approximate YTM = (C+ ((B-P)/Y))/ ((B+P)/2)

The spread formula involves subtracting the YTM of the first bond from the YTM of the second bond to determine the bond yield spread. Read the bond-yield spread in terms of basis points, instead of dollars. For example, if one bond's YTM is .08 and another's is .07, the spread would be one basis point, or .01.

Final Thoughts on Calculating Spread

Stock spreads can change daily, hourly or even by the minute. So, it would be best if you set up a spreadsheet formula to allow you to quickly calculate spreads several times throughout the day to save time compared to performing the calculation by hand every time.

Read More​: Bond Z-Spread for Beginners