Bid-ask spread

The bid-ask spread is one of the most important measures of market liquidity and trading effectiveness. In addition to serving as a gauge of the overall buying-selling attitude in the market, it is a significant factor in determining the cost of transactions for market players. While a greater spread could imply less liquidity and possible price volatility, a smaller spread usually signals more active trading and reduced transaction costs. Understanding the bid-ask spread is crucial for traders and investors to make well-informed decisions when purchasing and selling stocks.

Table of Contents

What is a bid-ask spread?
Understanding bid-ask spread
Working of bid-ask spread
Types of bid-ask spread
Frequently Asked Questions

What is a bid-ask spread?

The difference between the highest price a buyer is ready to pay and the lowest price a seller is willing to accept is known as the bid-ask spread. At the seller’s discretion, a bidder submits a “bid” to purchase at a specific “ask” price. The difference between these prices is called the ‘spread’. It is essential to understand a bid-ask spread thoroughly as it affects a market participant’s profitability.

Understanding bid-ask spread

A certain market instrument or derivative’s liquidity can be directly determined by looking at bid-ask spreads. Market makers, essentially an exchange, receive the transaction orders that market players place through several brokers. These market makers then aggregate the orders and create a live bid-ask spread that updates automatically. A more significant number of market players interested in trading a specific financial instrument will result in a deeper bid-ask spread and, consequently, lower transaction costs for both buyers and sellers.

Compared to markets with a firm spread, those with a broad bid-ask spread are usually less liquid. The spread widens because there isn’t a lot of demand and supply or an easy way to match buy and sell orders. The market maker receives compensation for the illiquidity through a more extensive spread, representing the higher transaction cost.

On the other hand, markets with a thin or narrower bid-ask spread are usually very liquid and have lots of buy and sell orders from traders. Highly traded stocks, like Microsoft, Apple, and Amazon, have narrower spreads because of the significant demand and supply for their stock. These kinds of blue-chip firms’ stocks make it easy for market makers to identify buyers or sellers. Due to a lack of investor interest, smaller-cap stocks or less well-known companies may have more excellent spreads.

Working of bid-ask spread

Brokers or market makers offer securities or assets with two price tags. For an asset, they list the cost price—also known as the bid price—and the selling price—also known as the asking price.

The ask is the lowest price the seller is willing to accept for the same item, and the bid is the highest price the buyer is willing to pay for it. Because more buyers and sellers are looking to trade, a narrow gap will suggest that there is a high amount of liquidity for the security. In contrast, a significant gap indicates that there are comparatively fewer traders for that asset, indicating lower liquidity of the instrument.

Investors evaluate the bid-ask spread pricing when deciding whether to purchase or sell stocks. They select one of the two options based on how they see profitability. The market makers who propose the transaction will benefit from the difference between the bid and ask prices, regardless of the bid-ask spread choices they select.

Types of bid-ask spread

Quoted spread

The quoted spread is the most basic kind of bid-ask spread. It is derived directly from featured prices or quotations. The quoted spread is the difference between the minimum asking price (the lowest price anyone will sell) and the maximum bid price (the highest price anyone will buy), expressed in quotations.

Effective spread

When a dealer offers a better price than what is quoted, a practice called “trading inside the spread” or “price improvement,” quoted spreads sometimes overstate the spreads that traders ultimately pay. Measuring the effective spread is more complicated than measuring the quoted spread because it requires accounting for reporting delays and matching trades to quotations (at least in the days before electronic trading).

Realised spread

Quoted and effective spreads represent traders’ expenses. These expenses include the cost of asymmetrical information, the loss to better-informed traders, immediacy, or the expense of having an intermediary execute a trade. The realised spread separates this real cost, which is the price of immediacy.

Frequently Asked Questions

Is a high bid-ask spread good?

No, a high bid-ask spread is not good as it essentially indicates that there is a significant difference between the price a buyer is willing to pay against the price a seller is willing to sell a particular security. Hence, it would result in a high transaction cost and might affect profitability.

What is the bid-ask spread formula example?

The bid-ask formula is ask price—bid price. For example, if a buyer is willing to pay US$100 against a seller’s ask price of US$110, then the bid-ask spread becomes 110–100= 10.

Is a low bid-ask spread good?

A low bid-ask spread or a narrow spread means that the particular financial instrument is liquid enough with minimal difference between the bid and ask prices from buyers and sellers. Hence, it would not be attributed to transaction costs and won’t affect the profitability of market participants.

What are the risks of bid-ask spread?

In addition to higher transaction charges and possible price manipulation, traders should be aware of the risks associated with the bid-ask spread. Wider spreads can reduce revenues by increasing the cost of incorporating and exiting trades. Furthermore, spreads can significantly expand during extreme volatility or lack of liquidity, making it harder to execute transactions at the prices you desire.

What are the benefits of bid-ask spread?

The bid-ask spread connects buyers and sellers, hence supplying liquidity and promoting efficient and seamless trade. It also provides price discovery by replicating the dynamics of market demand and supply. It also compensates market makers, encouraging them to maintain liquidity. Additionally, traders may evaluate market mood and volatility with the use of bid-ask spreads.