What Is a Bid-Ask Spread, and How Does It Work in Trading?
A bid-ask spread is an amount by which the asking price exceeds the bid price for an asset in the market. The bid-ask spread is the difference between the highest price a buyer is willing to pay for an asset and the lowest price a seller is willing to accept. An individual looking to sell will receive the bid price, while one looking to buy will pay the asking price.
Understanding Bid-Ask Spreads
A security’s price is the market’s unique perception of its value at any given time. To understand why there is a “bid” and an “ask,” one must factor in the two major players in any market transaction, namely the price taker (trader) and the market maker (counterparty).
Market makers, many of whom may be employed by brokerages, offer to sell securities at a given price (the asking price) and bid to purchase securities at a given price (the bid price). When an investor initiates a trade, they will accept one of these two prices depending on whether they wish to buy the security (ask price) or sell the security (bid price).
The difference between these two, the spread, is the principal transaction cost of trading (outside commissions), and it is collected by the market maker through the natural flow of processing orders at the bid and ask prices. This is what financial brokerages mean when they state that their revenues are derived from traders “crossing the spread.”
The bid-ask spread can be considered a measure of the supply and demand for a particular asset. The bid can be said to represent the demand for an asset, and the ask represents the supply, so when these two prices move apart, the price action reflects a change in supply and demand.
The depth of the “bids” and the “asks” can significantly impact the bid-ask spread. The spread may widen significantly if fewer participants place limited orders to buy a security (thus generating fewer bid prices) or if fewer sellers place limited orders to sell. As such, it’s critical to keep the bid-ask spread in mind when placing a buy-limit order to ensure it executes successfully.
Market makers and professional traders who recognize imminent risk may also widen the difference between the best bid and the best ask they are willing to offer at a given moment. If all market makers do this on a given security, the quoted bid-ask spread will reflect a larger size than usual. Some high-frequency traders and market makers attempt to make money by exploiting changes in the bid-ask spread.
The Bid-Ask Spread’s Relation to Liquidity
The size of the bid-ask spread from one asset to another differs mainly because of each asset’s liquidity difference. The bid-ask spread is the de facto measure of market liquidity. Specific markets are more liquid than others, which should be reflected in their lower spreads. Transaction initiators (price takers) demand liquidity, while counterparties (market makers) supply liquidity.
For example, the currency is considered the most liquid asset in the world, and the bid-ask spread in the currency market is one of the smallest (one-hundredth of a percent); in other words, the spread can be measured in fractions of pennies. On the other hand, less liquid assets, such as small-cap stocks, may have spreads equivalent to 1% to 2% of the asset’s lowest ask price.
Bid-ask spreads can also reflect the market maker’s perceived risk in offering a trade. For example, options or futures contracts may have bid-ask spreads representing a much more significant percentage of their price than a forex or equities trade. The width of the spread might be based not only on liquidity but also on how quickly the prices could change.
Bid-Ask Spread Example
If the bid price for a stock is $19 and the asking price for the same stock is $20, then the bid-ask spread for the stock in question is $1. The bid-ask spread can also be stated in percentage terms, customarily calculated as a percentage of the lowest sell price or ask price.
For the stock in the example above, the bid-ask spread in percentage terms would be $1 divided by $20 (the bid-ask spread divided by the lowest ask price) to yield a bid-ask spread of 5% ($1 x $20 x 100). This spread would close if a potential buyer offered to purchase the stock at a higher price or if a potential seller offered to sell the stock at a lower price.
Elements of the Bid-Ask Spread
Bid-ask spread Trades can be made in most securities, foreign exchange, and commodities. Traders use the bid-ask spread as an indicator of market liquidity. High friction between the supply and demand for that security will create a wider spread.
Most traders prefer to use limit orders instead of market orders; this allows them to choose their entry points rather than accepting the current market price. There is a cost involved with the bid-ask spread, as two trades are being conducted simultaneously.
How Does Bid-Ask Spread Work?
In financial markets, a bid-ask spread is the difference between the asking price and the bidding price of a security or other asset. The bid-ask spread is the difference between the highest price a buyer will offer (the bid price) and the lowest price a seller will accept (the asking price). Typically, an asset with a narrow bid-ask spread will have high demand. By contrast, assets with a wide bid-ask spread may have a low volume of demand, therefore influencing wider discrepancies in their price.
What Causes a Bid-Ask Spread to Be High?
Bid-ask spread, or “spread,” can be high due to several factors. First, liquidity plays a primary role. When there is a significant amount of liquidity in a given market for a security, the spread will be tighter. Stocks that trade heavily, such as Google, Apple, and Microsoft, will have a smaller bid-ask spread.
Conversely, a bid-ask spread may be high for unknown or unpopular securities on a given day. These could include small-cap stocks, which may have lower trading volumes and a lower level of demand among investors.
What Is an Example of a Bid-Ask Spread in Stocks?
Consider the following example: a trader is looking to purchase 100 shares of Apple for $50. The trader sees that 100 shares are being offered at $50.05. Her read would be $50.00–$50.05, or $0.05 wide. While this spread may seem minor or insignificant, it can create a meaningful difference on large trades, so narrow spreads are typically more ideal. In this instance, the total value of the bid-ask spread would be equal to 100 shares x $0.05, or $5.
The bid-ask spread is an effective measure of liquidity, as more liquid securities will have small spreads while illiquid ones will have larger ones. Investors should keep an eye on the spread of any security they wish to buy or sell to get a sense of how frequently it trades and to decide on the type of order to use when making a transaction.
Conclusion
- A bid-ask spread is the difference between the highest price a buyer is willing to pay for an asset and the lowest price a seller is willing to accept.
- The spread is the transaction cost. Price takers buy at the asking price and sell at the bid price, but the market maker buys at the bid price and sells at the asking price.
- The bid represents demand, and the ask represents supply for an asset.
- The bid-ask spread is the de facto measure of market liquidity.
