One of the most confusing and, at the same time, important aspects of investing is determining how much risk you’re willing to take on. Just like with any other part of your life, you have the option of assuming too much risk and ending up in a bad situation. Or, you can be mindful of how much you’re risking and end up in a good one.
What exactly is spread and margin, and how do they compare to each other?
What is Spread?
Spreads are the difference between the cost of buying and selling a certain security or stock. To understand the concept of spread, let’s take a look at two very basic examples.
Say you’re interested in purchasing 1000 shares of a company’s stock at $30.00 per share. To do this, you’ll need to make a $30,000 investment. Now, assuming you want to sell those 1000 shares at $35.00 per share, the overall spread is $5.00 per share (or $5.00 per 1000 shares). In this example, you’re enjoying a $5.00 profit per share (or $5.00 per 1000 shares) simply for taking on the spread risk (of buying at $30.00 per share and selling at $35.00 per share).
Let’s look at another example. Say you’re interested in purchasing 5000 shares of a company’s stock at $25.00 per share. To do this, you’ll need to make a $25,000 investment. Now, if you decide to sell those 5000 shares at $30.00 per share, the overall spread is $5.00 per share (or $5.00 per 5000 shares). In this example, you’re enjoying a $5.00 profit per share (or $5.00 per 5000 shares) simply for taking on the spread risk (of buying at $25.00 per share and selling at $30.00 per share).
Based on these two examples, you can see that the more expensive the stock, the wider (or more expensive the spread) the profit opportunity. So, when you have a large amount of investment capital, it’s usually a good idea to look for stocks that are more expensive, and thus offer wider spreads. When you have a small amount of investment capital, it might be better to look for cheaper stocks with narrower spreads.
What Is Margin?
Margin is simply the extra money that you put down (or loaned) to invest. So, in the example above, if you’re purchasing 1000 shares of AIG stock with a $25,000 margin loan, you’re essentially saying that you’re ready and willing to put up $25,000 more than the $25,000 you already invested to take on the spread (or risk) of buying the shares at $25.00 per share and selling them at $30.00 per share. ($50,000 total investment).
Let’s look at another example. Say you’re interested in purchasing 100,000 shares of a company’s stock at $20.00 per share. To do this, you’ll need to put down a $200,000 margin loan. In this case, you’re assuming a very high degree of risk (more on this below) but are enjoying a $20.00 per share profit (or $200,000 total profit). In this example, you’re enjoying a $20.00 profit per share (or $200,000 total profit) simply for taking on the risk (of purchasing at $20.00 per share and selling at $30.00 per share).
In general, the more money you have to invest, the wider the profit potential. But how much money you have to invest varies from stock to stock. One thing is for sure. The more expensive the stock, the wider the profit potential. It’s all about how much you’re willing to risk.
Key Takeaways
Spreads are the difference between the cost of buying and selling a certain security or stock. To understand the concept of spread, let’s take a look at two very basic examples.
The first example is simple. Say you’re interested in purchasing 1000 shares of a company’s stock at $30.00 per share. To do this, you’ll need to make a $30,000 investment. Now, assuming you want to sell those 1000 shares at $35.00 per share, the overall spread is $5.00 per share (or $5.00 per 1000 shares). In this case, you’re enjoying a $5.00 profit per share (or $5.00 per 1000 shares) simply for taking on the spread (or risk) of buying the shares at $30.00 per share and selling at $35.00 per share.
The second example is more complex. Say you’re interested in purchasing 5000 shares of a company’s stock at $25.00 per share. To do this, you’ll need to make a $25,000 investment. Now, if you decide to sell those 5000 shares at $30.00 per share, the overall spread is $5.00 per share (or $5.00 per 5000 shares). In this case, you’re enjoying a $5.00 profit per share (or $5.00 per 5000 shares) simply for taking on the spread (or risk) of buying the shares at $25.00 per share and selling at $30.00 per share.
Based on these two examples, you can see that the more expensive the stock, the wider the profit opportunity. When you have a large amount of investment capital, it’s usually a good idea to look for stocks that are more expensive, and thus offer wider spreads. When you have a small amount of investment capital, it might be better to look for cheaper stocks with narrower spreads.