Understanding the benefits of the Bid-Offer Spread

The Benefits of Bid-Offer Spreads

What does it mean when we say the energy complex is highly liquid with a tight bid offer spread? Is it a good thing?

One thing traders look for is the ability to get in and out of a market efficiently. A tight bid-offer spread makes that possible.

Tight Bid-Offer in Futures versus ETFs

An ETF is a security that tracks an index, a commodity, or a basket of assets like an index fund but trades like a stock on an exchange. A futures contract, on the other hand, is a contractual agreement to buy or sell a particular commodity or financial instrument at a predetermined price in the future. 

Example

A Crude Oil futures contract is currently priced at $100 per barrel and one futures contract is comprised of 1,000 barrels of oil. One thousand barrels times $100 gives the trader control of a notional value of $100,000. Since the minimum price fluctuation, or tick, for this contract is $0.01 per barrel, then a one-tick change would be worth $10.

Crude Oil Futures Notional = 1,000 barrels X $100

Crude Oil Futures Notional = $100,000

If the current price of a crude oil ETF share is $38, in order for an investor to manage the same notional value of one futures contract ($100,000), the investor would need to purchase the equivalent of 2,632 ETF shares.

Assuming 1 Oil ETF share = $38

Number of ETF shares to equate to 1 oil futures contract notional = $100,000 / $38 = 2,632 shares

Assume the ETF also trades in $0.01 increments. A one-tick price movement in the ETF position would equate to a change of $26.32 while a one-tick move in the futures contract is only $10. 

Conclusion

Tight bid offer spreads may lower one of the costs associated with getting into and out of a position.