When you first look at this chart, I think people have two thoughts. First, “wow, I didn’t realize how much spreads have widened in a few years,” and second, “wait…this is in cents per share. Haven’t stock prices gone through the roof since 2018?.” You’d be right on both points. Since 2018, the average stock price in the S&P 500 has increased 60%. It’s a significant increase, but it doesn’t fully explain the spread increases.

As spreads widen, the NBBO is a less accurate measure because it’s widened out by default. Historically, NBBO is often seen as the most precise measure of “true” spread (at the time of execution) and is extensively used for TCA and cost analysis work.

As a refresher, the National Best Bid and Offer (NBBO) reports the highest bid (price to buy) and the lowest ask (price to sell) for a security. Since bids are lower than asks, the concept is to show the tightest price range.

The example above shows how the NBBO gathers data from multiple exchanges. It also highlights a mid-point of 25.28 (half of the NBBO spread).

But, how do we know or value a “good” trade if more volume is occurring outside this range? And, how much volume happens outside the Mid? A lot, actually.

The BofA data indicates mid-point execution is consistently about 20-25% of traded volume on the S&P 500 (including on and off-exchange execution). That leaves 75-80% of trade volume occurring outside the mid.

For lower-priced stocks, most trades occur at the Bid or Ask (not the Mid). For higher-priced stocks, it’s more evenly distributed (this supports the increase in intraspread data we see above).

Before we discuss trade strategies, let’s think more about the relationship between volume and spread. The fine folks at BofA offer a few ideas. If you want more information, I recommend you contact them. But, here is what I thought was most interesting.

Also, much of what they discuss relates to liquidity (or volume) curves during the day. I will publish a piece on that shortly, so keep an eye out!

• End-of-day volumes continue to increase. So, it may be easier to cross spreads with limited impact given the increased liquidity.
• Conversely, spreads are widest at market open. Given this wider distribution, the available intraspread volume is also higher. Retail flow is most active around market open, too.

I’m going to link this back to Transition Management. For years, we suggested there is no “one-size-fits-all” solution to portfolio or transition management trading. It seems block desks are starting to consider this now for single stocks, too.

Part of the answer is – and as BofA suggests – a need for traders’ execution strategies to change and “vary depending on stock price, time of day, and venue.” If they aren’t already, traders need to be more versed on how individual stocks trade, and there shouldn’t be a rush to execute a trade on a generic algo or as a market execution without some forethought.

The other part of the answer is to think about benchmarking. Both TCA and pre-trade systems may use NBBO as a reasonable benchmark for price discovery and cost modeling. But, the data indicates this is less relevant in today’s markets. Using models (home-build or off the shelf) that can better analyze the spread distribution in aggregate and throughout the trading day empowers traders to make better execution decisions.

Sources:

BofA Securities. “When the Best isn’t Good Enough: Trading Inside the “Best” Bid-Offer. April 12, 2022.

Charles Schwab. Understanding Price Improvement. https://www.schwab.com/execution-quality/price-improvement

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