The Lemon Fool

Wide spreads with the mid price unchanged disadvantage both buyers and sellers

an illogical statement, during times of market stress the mid price falls , otherwise their would be no stress.

Market makers can increase spreads because of market volatility. :

To me this statement indicates a misunderstanding of why market makers set a spread, , when shares are falling during stressful periods it is because there are more sellers than buyers, in theory a market maker can set their offer price wherever they wish in reality they will choose to disadvantage the sellers in favor of buyers otherwise they run the danger of accumulating an inventory that they cannot shift before the price falls even more, remember that for the banks who engage in market making this is supposed to be a low risk way of making money, they have to sell stock quickly during volatile times or they run the risk of having to sell at a lower price than they bought the shares for, this is not what market making is all about so putting of buyers is the last thing they want to do.

Yes ETFS can trade at premiums and discounts but nothing like investment trusts.

The Lyxor 0-5 year gilt ETF GIL5 appears to have lower spread than most ETFs, which I expect is a result of its low volatility:

Or maybe Lyxor are making the market and just want to see their fund traded more , in one other word it's the result of competition in the market.
Preference shares which are not often traded can have bid offer spreads of 5% . It is precisely because they are relatively iliquid and not often traded that their share prices are not usually volatile.

colin wrote:

Wide spreads with the mid price unchanged disadvantage both buyers and sellers

an illogical statement, during times of market stress the mid price falls , otherwise their would be no stress.

If market volatility increases, market makers increase their spreads. It does not have to be a time of market stress for this to happen. Volatility is random price movement both up and down. If the price is bouncing about like a yo-yo, market makers want wider spreads to reduce their risk in holding stocks of shares.

If an ETF is sold heavily, the ETF price falls to a discount to the NAV. Normally, market participants would arbitrage the discount away, by buying baskets of the shares within the ETF at a discount, and selling them in the market. If the market falls heavily, the market participants may have difficulty getting a good price for the shares, and may not be willing to buy them from the ETF.

Rapid falls in the market are accompanied by increases in volatility and increases in both share and ETF spreads.

colin wrote:

Market makers can increase spreads because of market volatility. :

To me this statement indicates a misunderstanding of why market makers set a spread, , when shares are falling during stressful periods it is because there are more sellers than buyers, in theory a market maker can set their offer price wherever they wish in reality they will choose to disadvantage the sellers in favor of buyers otherwise they run the danger of accumulating an inventory that they cannot shift before the price falls even more, remember that for the banks who engage in market making this is supposed to be a low risk way of making money, they have to sell stock quickly during volatile times or they run the risk of having to sell at a lower price than they bought the shares for, this is not what market making is all about so putting of buyers is the last thing they want to do.

Yes ETFS can trade at premiums and discounts but nothing like investment trusts.

The Lyxor 0-5 year gilt ETF GIL5 appears to have lower spread than most ETFs, which I expect is a result of its low volatility:

Or maybe Lyxor are making the market and just want to see their fund traded more , in one other word it's the result of competition in the market.
Preference shares which are not often traded can have bid offer spreads of 5% . It is precisely because they are relatively iliquid and not often traded that their share prices are not usually volatile.

For every buyer there is a seller. There are never more sellers than buyers. If the price is rising rapidly, market makers will usually be happy to hold an inventory of shares, because they can sell them quickly. Market makers want both sellers and buyers, and have to set their prices accordingly.

The link I posted previously gives examples of ETFs with enormous premiums and discounts to NAV, but this is not usual.

Lyxor's more volatile long gilt fund GILS appears to have consistently wider spreads than the short dates GIL5. The market makers set the spread, not Lyxor, so marking considerations are not relevant here.

In the case of illiquid preference shares, the market maker is going to be unwilling to hold an inventory because because he is uncertain about the price, and it may move before he finds a buyer.

The top answer here is rather a technical answer to how market makers set market spread:

https://www.quora.com/How-do-market-mak ... -two-ticks

For every buyer there is a seller. There are never more sellers than buyers

This statement is nonsense, if buyers and sellers were always evenly matched the price of shares would never change .

The fact that preference shares have relatively wide bid offer spreads compared to more frequently traded securities proves that your contention that low volatility equals low bid offer spreads is just plain wrong.

Every professional financial author that I have ever read on the subject informs me that low bid offer spreads are a result of competition among market makers for a share in the business of trading highly liquid securities (that is shares which are frequently traded).

The market makers set the spread, not Lyxor,

my point was that lyxor might well be a market maker, I don't know but why not? In any case it does not matter your position that low volatility equals low bid offer spread is wrong.

Lyxor's more volatile long gilt fund GILS appears to have consistently wider spreads than the short dates GIL5

Perhaps the longer dated bonds are less frequently traded.

Rapid falls in the market are accompanied by increases in volatility and increases in both share and ETF spreads

Yes this is true, but that does not imply a causality between low bid offer spreads and low volatility. And that's where the root of your misunderstanding lies.

There is no point in adding to what I have said. People can look at the links I have given. I am sure Google will be happy to provide further information.

There is no point in adding to what I have said

This is a discussion board, it's very purpose in existing is to allow people to add to whatever you might say, especially when we believe your
thinking to be somewhat confused

Just in case anyone is interested, here is a paper that gives the basic mathematics here:

https://arxiv.org/ftp/arxiv/papers/1606/1606.07381.pdf

Theoretically, the spread is directly proportional to the volatility. This linear relationship usually holds very well in practice. See the charts in the paper.

Theoretically, the spread is directly proportional to the volatility

oh really?
Santander preference shares

http://www.hl.co.uk/shares/shares-search-results/s/santander-uk-plc-10-38-non-cum-stlg-pre
bid offer spread = %2.8 of the offer price
Santander ordinary shares
http://www.hl.co.uk/shares/shares-search-results/b/banco-santander-sa-eur0.50
bid offer spread = .14% of the offer price

Any one can see from the performance charts which security is the more volatile.

I am not disagreeing with you if you are trying to say that bid offer spreads widen during times of market trauma, I remember when the equivalent spread on Santander prefs was 5%, I am disagreeing with you when you say that during such times the buyers are not advantaged relative to the sellers , and I am disagreeing with you when you imply that lower volatility securities have lower bid offer spreads. You can post all the links to theoretical studies you like but the facts are somewhat simpler and plain to see.

colin wrote:

Theoretically, the spread is directly proportional to the volatility

oh really?
Santander preference shares

http://www.hl.co.uk/shares/shares-search-results/s/santander-uk-plc-10-38-non-cum-stlg-pre
bid offer spread = %2.8 of the offer price
Santander ordinary shares
http://www.hl.co.uk/shares/shares-search-results/b/banco-santander-sa-eur0.50
bid offer spread = .14% of the offer price

Any one can see from the performance charts which security is the more volatile.

I am not disagreeing with you if you are trying to say that bid offer spreads widen during times of market trauma, I remember when the equivalent spread on Santander prefs was 5%, I am disagreeing with you when you say that during such times the buyers are not advantaged relative to the sellers , and I am disagreeing with you when you imply that lower volatility securities have lower bid offer spreads. You can post all the links to theoretical studies you like but the facts are somewhat simpler and plain to see.

The volatility is only one factor in the equation governing the spread. The spread is also proportional to the square root of the transaction size divided by the volume.

Market makers try to match orders with those in the order book if they can, adding on some extra spread.

When the price falls, clearly buyers have been advantaged relative to sellers, even if there is no spread. i have never said otherwise. A widening spread makes more expensive to buy, and also lowers the price that a seller will receive, in equal measure.

Perhaps it is worth adding here that when we talk of the stock price, without qualification, we mean the mid-market price. The bid and offer prices are equally spread around the mid-market price by definition.

Stock prices do not fall because there are more sellers than buyers. They fall when sellers are willing to sell below the market price, and buyers are only willing to buy if they are offered a price below the market price. Traders who put optimistic limit orders into the order book provide liquidity to those who want to trade in a hurry.

In some market conditions, the spreads can deviate significantly from the theoretical value:

https://www.bloomberg.com/professional/ ... -ftse-100/

On Brexit day, FTSE 100 spreads were kept lower than the theoretical value because market makers were able to make money from the momentum. There is a lot of complexity in the details here.

On Brexit day, FTSE 100 spreads were kept lower than the theoretical value because market makers were able to make money from the momentum. There is a lot of complexity in the details here.

Well yes exactly, in the real world profits count not theory, you have just demonstrated that your contention low volatility = low bid offer spread is and always was nonsense. It is not an issue of complexity more an issue of your ideas not corresponding to reality, ie plain wrong.

colin wrote:

On Brexit day, FTSE 100 spreads were kept lower than the theoretical value because market makers were able to make money from the momentum. There is a lot of complexity in the details here.

Well yes exactly, in the real world profits count not theory, you have just demonstrated that your contention low volatility = low bid offer spread is and always was nonsense. It is not an issue of complexity more an issue of your ideas not corresponding to reality, ie plain wrong.

The theoretical calculation is accurate in most market conditions. It is not my calculation. It forms the basis of market making, but market makers sometimes take trading positions. As I have already said, the formula says that lower volatility implies lower spreads only if all other factors are equal. The formula is equivalent to the one used in the Bloomberg article.

Well I have already presented you with an example from the real world which contradicts your pet theory, here are some more.

All S&P 500 index tracker ETFs

Lyxor SP5 bid offer spread = .32% of buy price

iShares CSPX bid offer spread= .02% of buy price

Vanguard VUSA bid offer spread = .05% of buy price
all taken from last Fridays closing prices.

All tracking exactly the same index so all experiencing the same volatility yet each one carrying a different bid offer spread.
I should take no more notice of theories if I were you.

If you believe that the theory in the references that I have given predicts that those ETFs will have the same spread, you have not understood much of what I have written, and certainly have not understood the references.

When you write

Theoretically, the spread is directly proportional to the volatility

What other meaning is one expected to take? the opposite of what you say? your reasoning is absurd!

colin wrote:When you write

Theoretically, the spread is directly proportional to the volatility

What other meaning is one expected to take? the opposite of what you say? your reasoning is absurd!

My statement is absolutely correct. Perhaps you do not understand the meaning of "directly proportional":

https://www.mathsisfun.com/algebra/dire ... ional.html

Distance travelled is directly proportional to speed, and also directly proportional to time. If two cars travel at the same speed, they do not necessarily travel the same distance. One car might be travelling for one hour and the other for two hours.

I also wrote:

"The volatility is only one factor in the equation governing the spread. The spread is also proportional to the square root of the transaction size divided by the volume."

If the volatility of two shares is the same, the less liquid share will have the wider spread, provided that all other factors are the same.