What Is Proportional Spread?
Higher proportional spreads are associated with less liquid securities, allowing market makers to be compensated for the added risk of dealing in illiquid securities. On the other hand, more liquid securities will have lower proportional spreads.
- Proportional spread is a measure of a security’s liquidity that is calculated by comparing its bid and ask prices.
- It is larger in less liquid securities and smaller in more liquid ones, which helps compensate market makers for the risk of dealing in illiquid securities.
- Average proportional spreads have decreased significantly in recent years.
How Proportional Spreads Work
The proportional spread is calculated as the difference between the closing ask and bid prices, divided by their average:
Proportional Spread = (Ask - Bid) / (Ask + Bid) ÷ 2
Ask = The highest close in the month
Bid = The lowest close in the month
The proportional spread can be interpreted as the average compensation paid to dealers for making a market in that security. From the perspective of the investor, the average cost of transacting in that security is equal to one half of the proportional spread. In general, proportional spreads range between 0.50% and about 3%.
Proportional spreads are important to investors because they influence the net cost basis of purchasing shares. This in turn can eat into the proceeds received when selling shares. For popular and liquid securities, however, proportional spreads are often so minimal as to have very little effect on investors.
Some investors deliberately seek out illiquid markets in which proportional spreads are higher than normal. In these markets, it is sometimes possible to find examples of extreme security misvaluations—that is, securities that are mispriced relative to their intrinsic value. This approach to investing is often employed by value investors.
Real World Example of Proportional Spreads
In the early 2000s, the average proportional spread associated with trading on the New York Stock Exchange (NYSE) was 0.6%. However, with the growth in popularity of electronic trading platforms, the market-making process has become increasingly efficient in recent years. This has contributed to a decline in the average proportional spread to less than 0.2% today.
It is important to note however that this is only an average figure. For highly liquid securities, in which millions or even tens of millions of shares change hands each trading session, the proportional spread can be just a few basis points. On the other hand, securities that have very little volume can have much higher proportional spreads.
In addition to these factors, proportional spreads can also be affected by the lot size of the order in question. For instance, a block trade would be subject to a lower proportional spread, whereas an odd lot trade would be subject to a higher one.