Can someone explain the logic of the effective spread calculation. Mainly, why do we multiply the difference between the execution price and midquote by 2? and then compare it to the quoted spread?
The spread always has two sides, bid to midpoint and midpoint to ask. The effective spread makes the assumption that the mid-point does not change between when the price is quoted, and when the deal is executed. Say you are buying stock that was quoted at bid 1.01 and ask 1.05 - we can calculate the midpoint at 1.03, and your spread is 0.04 You actually sell at 1.02 - therefore “assuming” the midpoint has stayed the same, you have got a better price than when you decided to execute the deal. Effectively, the spread you paid is 0.02, which is better than what you would have paid if your decision to trade, and execution occurred simultaneously.
Which is the correct calculations for effective spread: 2( Execution - Midpoint) or 2( Midpoint - Execution). The CFA text use it both ways see the bottom of pg 13 and calculations on pg 14 in volume 6 (2010 series)
Depends on whether you are buying or selling, makes sense?
Perhaps it helps to visualize: --------------------------Bid-----------------------Mid------------------------Ask-------------------------- || ||
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- When executed price is bid or ask of the quote 2. don’t know how it can be gamed.