Bid-Ask Spread

What is a Bid-Ask Spread?

A bid-ask spread is the amount by which the ask price exceeds the bid price for an asset in the market. The bid-ask spread is essentially the difference between the highest price that a buyer is willing to pay for an asset and the lowest price that a seller is willing to accept. An individual looking to sell will receive the bid price while one looking to buy will pay the ask price.

A Bid-Ask Spread is the difference between the highest price a buyer of a security or other asset is willing to pay and the lowest price a seller is willing to offer. Generally speaking, the more liquid an asset is, the lower the bid-ask spread is. As a result, currency, which is considered the most liquid asset, has an extremely low bid-ask spread.

A bid–ask spread (also bid–offer or bid/ask and buy/sell in the case of a market maker), is the difference between the prices quoted (either by a single market maker or in a limit order book) for an immediate sale (offer) and an immediate purchase (bid) for stocks, futures contracts, options, or currency pairs. The size of the bid–ask spread in a security is one measure of the liquidity of the market and of the size of the transaction cost. If the spread is 0 then it is a frictionless asset.

What Does Bid-Ask Spread Mean?

Bid-Ask Spread is typically the difference between ask (offer/sell) price and bid (purchase/buy) price of a security. Ask price is the value point at which the seller is ready to sell and bid price is the point at which a buyer is ready to buy. When the two value points match in a marketplace, i.e. when a buyer and a seller agree to the prices being offered by each other, a trade takes place. These prices are determined by two market forces — demand and supply, and the gap between these two forces defines the spread between buy-sell prices. The larger the gap, the greater the spread! Bid-Ask Spread can be expressed in absolute as well as percentage terms. When the market is highly liquid, spread values can be very small, but when the market is illiquid or less liquid, they can be large.

Bid-Ask spread is used in following arbitrage trades:

  1. Inter-market spread: When a trader buys the futures of a security having a particular expiry on one exchange and sells the same security contract with a near-expiry on another exchange;
  2. Intra-market spread: When the contract of one security is bought and that of another security is sold on the same exchange e.g. gold and silver spread trade;
  3. Calendar spread: When a security contract of one expiry date is bought and another contract of the same security with a different expiry date is sold on the same exchange.

Some of the important elements to Bid-Ask Spread:

  • The market for any security should be highly liquid, otherwise there may be no ideal exit point to book profit in a spread trade.
  • There should be some friction in demand-supply of that security, because that creates chances for a wider spread.
  • A trader should not use ‘market order’ for spread trade, otherwise the spread opportunity can be missed. It’s wise to use ‘limit order’ where the trader decides the entry point.
  • The range of a spread trade is relative to that particular security market, it’s not same for all.
  • Always check Bid-Ask Spread ins and outs, and look for spreads either in absolute or percentage terms for individual security. If it’s a margin trade, then use spread percentage.
  • Bid-Ask Spread trade involves a cost, as you are doing two trades simultaneously.
  • Bid-Ask Spread trades can be done in almost all kinds of securities, but they are quite popular in forex, interest rate yields and commodities.

Liquidity

If the prices are very close to each other, this means that both buyer and seller have a fairly similar opinion of the value of whatever is being sold. A very small bid-ask spread indicates that the market is very efficient and both sides of the market have similar information or motivation. This is called a very “liquid” market, especially if there is considerable volume offered on both the bid and ask or on “either side of the market”.

The trader initiating the transaction is said to demand liquidity, and the other party (counterparty) to the transaction supplies liquidity. Liquidity demanders place market orders and liquidity suppliers place limit orders. For a round trip (a purchase and sale together) the liquidity demander pays the spread and the liquidity supplier earns the spread. All limit orders outstanding at a given time (i.e. limit orders that have not been executed) are together called the Limit Order Book. In some markets such as NASDAQ, dealers supply liquidity. However, on most exchanges, such as the Australian Securities Exchange, there are no designated liquidity suppliers, and liquidity is supplied by other traders. On these exchanges, and even on NASDAQ, institutions and individuals can supply liquidity by placing limit orders.

The bid–ask spread is an accepted measure of liquidity costs in exchange traded securities and commodities. On any standardized exchange, two elements comprise almost all of the transaction cost — brokerage fees and bid–ask spreads. Under competitive conditions, the bid–ask spread measures the cost of making transactions without delay. The difference in price paid by an urgent buyer and received by an urgent seller is the liquidity cost. Since brokerage commissions do not vary with the time taken to complete a transaction, differences in bid–ask spread indicate differences in the liquidity cost.

Six Big Takeaways on Bid-Ask Spreads

Once fully explained, the concept of bid and ask becomes easier for investors to understand, and to apply the spread into their trading decisions.

In doing so, though, make sure you’re taking these key points on bid-ask spreads into consideration:

  1. The bid price is the highest price a securities buyer will pay.
  2. The ask price is the lowest price a securities seller will accept.
  3. The ask price is often referred to as the “offer price.”
  4. When a bid price overlaps an ask price, a trade is usually executed.
  5. The more liquid a stock or fund is, the narrower is its bid-ask spread. Conversely, the lower the liquidity of a stock or fund, the wider the bid and ask spread. It’s not uncommon for widely traded stocks like Google to have a bid-ask price of a single penny.
  6. Perhaps the biggest driver of bid and ask spreads – besides liquidity – is supply and demand. The more a stock or fund is in demand, the narrower its spread. Highly volatile sticks can move bid and ask spreads around significantly, as well.

Types of Spreads

Quoted Spread

The simplest type of bid-ask spread is the quoted spread. This spread is taken directly from quotes, that is, posted prices. Using quotes, this spread is the difference between the lowest asking price (the lowest price at which someone will sell) and the highest bid price (the highest price at which someone will buy). This spread is often expressed as a percent of the midpoint, that is, the average between the lowest ask and highest bid:

Quoted spread = (Ask - Bid) ÷ Midpoint × 100%

Effective Spread

Quoted spreads often over-state the spreads finally paid by traders, due to “price improvement”, that is, a dealer offering a better price than the quotes, also known as “trading inside the spread”. Effective spreads account for this issue by using trade prices, and are typically defined as:

Effective spread = 2 × | Trade price - Midpoint | ÷ Midpoint × 100%

The effective spread is more difficult to measure than the quoted spread, since one needs to match trades with quotes and account for reporting delays (at least pre-electronic trading). Moreover, this definition embeds the assumption that trades above the midpoint are buys and trades below the midpoint are sales.

Realized Spread

Quoted and effective spreads represent costs incurred by traders. This cost includes both a cost of asymmetric information, that is, a loss to traders that are more informed, as well as a cost of immediacy, that is, a cost for having a trade being executed by an intermediary. The realized spread isolates the cost of immediacy, also known as the “real cost”. This spread is defined as:

Realized spread = 2 × | Midpointk+1 - Trade pricek | ÷ Midpointk × 100%

where the subscript k represents the kth trade.

The intuition for why this spread measures the cost of immediacy is that, after each trade, the dealer adjusts quotes to reflect the information in the trade (and inventory effects).

Inner price moves are moves of the bid-ask price where the spread has been deducted.

Bid-Ask Spread Example

If the bid price for a stock is $19 and the ask 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; it is 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 calculated as $1 divided by $20 (the bid-ask spread divided by the lowest ask price) to yield a bid-ask spread of 5% ($1 / $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.

Types of Orders

An individual can place five types of orders with a specialist or market maker:

  • Market Order – A market order can be filled at the market or prevailing price. By using the example above, if the buyer were to place an order to buy 1,500 shares, the buyer would receive 1,500 shares at the asking price of $10.25. If they placed a market order for 2,000 shares, the buyer would get 1,500 shares at $10.25 and 500 shares at the next best offer price, which might be higher than $10.25.
  • Limit Order – An individual places a limit order to sell or buy a certain amount of stock at a given price or better. Using the above spread example, an individual might place a limit order to sell 2,000 shares at $10. Upon placing such an order, the individual would immediately sell 1,000 shares at the existing offer of $10. Then, they might have to wait until another buyer comes along and bids $10 or better to fill the balance of the order. Again, the balance of the stock will not be sold unless the shares trade at $10 or above. If the stock stays below $10 a share, the seller might never be able to unload the stock. The key point an investor using limit orders must keep in mind is that if they are trying to buy, then the asking price, not merely the bid price, must fall to the level of their limit order price, or below, for the order to be filled.
  • Day Order – A day order is good only for that trading day. If it is not filled that day, the order is canceled.
  • Fill or Kill (FOK) – An FOK order must be filled immediately and in its entirety or not at all. For example, if a person were to put in an FOK order to sell 2,000 shares at $10, a buyer would take in all 2,000 shares at that price immediately or refuse the order, in which case it would be canceled.
  • Stop Order – A stop order goes to work when the stock passes a certain level. For example, suppose an investor wants to sell 1,000 shares of XYZ stock if it trades down to $9. In this case, the investor might place a stop order at $9 so that, when the stock does trade to that level, the order becomes effective as a market order. To be clear, this does not guarantee that the order will be executed at exactly $9, but it does guarantee that the stock will be sold. If sellers are abundant, the price at which the order is executed might be much lower than $9.

The Bid-Ask Spread and Its Importance to Day Traders

Trading illiquid securities can make sense in certain scenarios to obtain a specific type of exposure. Moreover, investors expect to be compensated extra for holding illiquid securities in what is called an “illiquidity premium”.

But the drawbacks include the need to pay an above-market price to buy a security, the potential inability to sell a security when desired, and the need to sell at some type of discount to get out of a position. This is why many traders always prefer to stay liquid, knowing they can effectively get in and out at any price.

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