Are spreads the right indicator of liquidity for your investment analysis?
Tom Jardine, Client Facing Data Scientist, BMLL
First published in TabbFORUM, 21 November 2023
For years, in the investment community, “spread” or the difference between a stock’s bid price and ask price has been a bellwether metric for liquidity. The logic was if a stock had a tight spread (small difference between bid and ask prices), the stock was liquid. And if the spread was wide, the stock was not as liquid and investors should tread lightly. A stock’s average spread over a certain time period is even one of the main parameters in many complex transaction cost models.
Yet simply relying on a stock’s displayed spread can be misleading and cause many institutional investors to miscalculate the true cost of investment. Let’s use an example to illustrate this potential miscalculation.
AAPL’s spread throughout a trading day is usually 1 to 2 cents wide, 178.73-178.75. But if you look at the size that can be traded on these quotes, there are often only 100 shares on each side, the minimum round lot size required for a market maker to provide a quote.
For an institutional investor looking to purchase 1-2 million shares over a day broken up into 1,000-10,000 share order sizes throughout the day, these quotes with only 100 shares on each side are not very effective measures for liquidity. An order of those sizes would blow right through the top of the book and into the higher price levels of the book.
A much more useful measure for an investor would be to know what the “spread” would be if they wanted to buy 500 or even 1,000 shares of a certain stock. This hypothetical spread metric would allow investors to use a much more applicable liquidity metric when estimating the cost of investment. At BMLL, we have created this exact measure and we call it our “Sweep to Fill” (STF) metric.
For each stock in our coverage universe, we have calculated this hypothetical spread for orders of size $25k, $50k, $100k and $250k going back over 5 years. An example comparing the two metrics will help to illustrate how much more effective the STF metric is versus a simple spread.
If we look at AAPL, we can see that the simple spread of AAPL (blue line) stays within a tight range of $0.013 to $0.016. This metric is not very helpful when trying to assess if standing liquidity has changed over time.
The much more effective STF metric (orange line) not only gives the investor a more realistic cost of executing a particular size order at any given time but also provides a better picture of how the cost now compares to an historical view.
AAPL’s STF, which dipped to ~ $0.04 in April and May of 2023, a clear indication of increased liquidity, doubled to over $0.08 at the end of September 2023 while the spread moved from ~ $0.013 to ~ $0.015 during that same time period.
Knowing this drastic change in STF should keep investors up at night. But if they only relied on the Level 1 spread graph, this 1 or 2 tenths of a penny change may give them a false sense of security and cost them dearly in investment impact.
Spreads are no longer enough to indicate the availability of liquidity for any investment analysis. Using Level 3 metrics shows greater visibility into the availability of liquidity. Contact BMLL to find out more about how the Sweep to Fill metric can help your organisation.
Read the article on TabbFORUM here.