How the Spreads are Calculated for Futures

Q. How are the spreads determined for stocks?


A: The bid-offer spreads for individual stocks are calculated as a percentage of the stock price. The main factor affecting the percentage is the liquidity in the market. If there is a wide spread in the underlying market (exchange) where your spread betting provider may hedge your trade, this will be reflected in the spread that the bookie quotes.

For instance Ayondo quotes -:

UK Shares: 0.1% either side
US Shares: 0.1% either side

Bigger companies that are traded on the SETS order book have high trading volumes so tend to have tighter spreads. Smaller caps and AIM stocks that depend on market makers for the liquidity tend to have wider spreads making them more expensive to trade.

Q: Why do spreads sometimes widen or tighten?

A: The spreads that the spread betting providers quote mirror the actual spreads available by the underlying market. In the case if LLOY stock for instance, IG Index charge 0.05p extra on the buy and sell side. So 54-55 will be 53.95-55.05. Spreads fluctuate constantly, sometimes quickly and sometimes slowly reflecting the activity in the underlying asset on which they are based. In a thinly traded market the underlying spread might widen out and the spread betting price would then automatically reflect this.

Likewise in a very volatile market, the price is much harder to predict and thereby the spreads are prone to be wider. But in stable markets like FTSE 100 stocks, the spreads are usually much tighter. It often pays out to have multiple accounts with different spread betting providers to compare spreads and pick the best deal for a particular trade.

Q: What about Futures? How are the spreads calculated there?

A: Bid-offers spreads are calculated in different ways according to whether the contract in question concerns daily rolling bets or futures. For future quarterly bets the base point would be the underlying market future price and the quote will reflect the cost of carry (i.e financing cost of the trade up to its expiry date) as well as include any dividend payments before the expiry date of the contract.

Sometimes these spreads will widen or tighten, this is all based on the movement and volatility of the underlying asset.

But what's the link between the underlying price of an instrument and the spread bet price?

The variables that make up a spread bet consist of the underlying asset and the time to expiry since taken as a whole these determine how the spreadbet will resolve if held to expiry. The time factor means that if you place a spreadbet on a stock index future, the mid-point of the spread will not usually match the prevailing cash market price of the instrument from the London Stock Exchange. If spreads are quoted at a premium to the cash price, this represents the surrender of interest that a spreadtrader experiences through buying the actual stock for cash as opposed to taking what is basically a forward position via a spreadbet. This difference is referred to as the 'fair value premium' and is lower if a share is likely to go ex-dividend at any time before the bet future expires, since for quarterly bets it is the shareholder who owns the shares and not the spread better who is entitled to receive the dividend income.

The adjustment for the interest and the dividend is simply an automatic calculation. The cost of carry will normally make the futures price higher than the cash price, but in some cases where a share is paying a dividend this can actually make the make the futures price less than the underlying.

Note that positions that are quoted directly from a futures contract such as the quarterly FTSE futures don't include this pricing adjustment as the cost of carry is already accounted for in the futures price. In such cases the spread betting providers will just wrap its spread around the futures market underlying contract price.

Alternatively, as opposed to futures you can spread bet directly on individual shares using daily bets or rolling cash bets which avoids this pricing adjustment and the quote is based directly on the cash price of the share. This makes them much more easier to compare with the physical market than quarterly futures and the spreads are tighter since the cost of carry (which is build into the futures spreadbets) is replaced by a small separate overnight financing fee that is charged each day the spreadbet is rolled over.

Daily bets (also referred to as intraday bets) expire on the same day that a position is opened although you can always ask for the contract to be rolled over to the next trading day. If a contract is indeed rolled over - the opening level of the new spreadbet will be adjusted to reflect the effect of interest (financing) as well as any dividends, although there will be no extra spread to pay. Rolling cash bets make this rolling process easier - the bets are rolled automatically every night until you close the bet. In practice, daily bets and rolling cash bets are great for day traders and short term traders since the spreads for these contracts are very tight (much tighter than the corresponding quarterly bet). On the other hand, futures bets are more appropriate for trading on longer timeframes.

 ...Continues here - More on Financing

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