The Difference Between Real and Fake Spreads


Who likes samiches; raise your hands! And who likes a nice hero, made on good bread with the right meats, cheeses, and real mayo? Raise em… We at Themis highly endorse Angie’s, who delivers us our occasional lunch samich on real baker-baked bread (no thin crusts)… you know the kind we are talking about – not that processed machine stuff, and real mayo. Why just this past Thursday, while recovering from our midday food induced comas, Joe remarked just how important a real spread was to the samich, whilst I happened to be looking at Nanex’s website. A bell went off, a horrible analogy between mayonnaise and equity spreads was born, and you have this morning note.

Nanex has examined spreads in a non-static fashion, and has demonstrated in two charts just how fragile our “narrow spreads” are today. Nanex picked two days where there were “data surges” – think news event, like a Fed announcement for example. The chart on the left is pre REG NMS (January 2007) while the chart on the right is February 2012. The X-axis is time measured in seconds, over 1 minute. The Y-axis is the number of stocks with increasing spreads (red) or decreasing spreads (purple). These charts taken together nicely explain liquidity vacuums and volatility that develop around the start of any market move, be it caused by a Fed announcement, or a fat-finger error. Note that we are comparing 2012 with 2007, as opposed to 2012 vs 1990, which is what HFT defenders always like to do. Nanex also wrote this great piece depicting disintegration of spreads during heavy trading.

What has speed done to our markets? We argue always that increasing the speed of orders and executions from 30 seconds down to 1 second has been great for market efficiency. However, the increase in market speed from 1 second down to millionths of a second has brought little benefit to investors, and much risk. Modern “developments” including machine readable algos, and “market makers” who can yank bids faster than you can hit them, have increased risk in trading, with very little marginal benefit. Except to HFT and the Exchanges. Spreads can and do disintegrate in the blink of an eye, and the “narrow spread” on 200 shares that your friendly DMM, as well as Vanguard’s Gus Sauter, exalts as proof that markets are better today, goes out the window.