Bid-Ask Spread

Complete Guide to Bid-Ask Spread - How it Works and Why Traders need to Use it

Definition: The bid-ask spread refers to the difference between the bid price and the asking price for a certain investment.

In other words, it represents the difference between the maximum amount a buyer is willing to pay for an instrument and the minimum price the seller is willing to take for the instrument.

What is Bid-Ask Spread?

The Bid Ask Spread is the difference between the selling and buying prices of an asset in the market. This metric is essentially the gap between the highest price that a buyer is willing to pay for an asset traded in the market and the lowest price that a seller is willing to accept. It is also seen as a transaction’s cost and a measure of an asset’s liquidity.

The bid ask spread is a concept that is widely used in trading, specifically relating to equities. Thus, trading professionals, financial professionals, and others frequently refer to the bid ask spread of a certain investment.

The bid price, or price a buyer is willing to pay, and the sell price, or the price a seller is willing to sell, are vital to determining the market for an investment. It is also important to institutional investors, such as hedge fund managers, who need to know the spread, especially for less liquid investments where the spread can be greater.

Key Takeaways

Liquidity Indicator: The bid-ask spread is a key indicator of a security’s liquidity; narrower spreads generally indicate higher liquidity, meaning the security can be bought or sold quickly without causing a significant impact on its price.

Cost of Trading: The bid-ask spread represents the cost investors incur when executing a trade, with wider spreads implying a higher cost due to the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask).

Market Sentiment and Volatility: Larger bid-ask spreads can also reflect higher market volatility or uncertainty, as traders and market makers demand a higher premium for the increased risk of trading under such conditions.

How is Bid Ask Spread Used in Trading/Investing?

The difference represented in the Bid Ask Spread provides a profit to the market maker. These large firms called market makers are typically financial institutions or large investment firms. They set a bid price that is slightly lower than the ask price and thus they create the spread.

If an investor wants to buy a security or a currency, he will pay the ask price to the market maker. If an investor wants to sell a security or a currency, he will obtain the bid price. On the opposite side, the market maker will buy at the bid price and sell at the ask price. That spread will provide a profit to the market maker.

The market maker quotes the Bid Ask prices but they move very frequently, especially for highly traded securities. The Bid Ask spread is a good indication of how liquid a security is a given point.

The Bid Ask Spread is one of the two most common transaction costs existing in large security exchanges. The other usual transaction cost is the brokerage fee. Buyers and sellers accept the existence of a Bid Ask Spread because market makers’ participation ensures liquidity.

They buy and sell large volumes and allow an investor to sell his assets at any time without worrying about the existence of a buyer. In the opposite situation, an investor can buy an asset at any time without worrying if there is a seller for this particular security.

New investors should be aware of the Bid Ask spread. It can be seen as a negligible cost in some cases, but in situations when an investor makes a significant number of transactions per day, this spread may total a relevant amount of money. It is also relevant when the investment horizon is too short as the investor has to consider the difference in his expectations.


Bid Ask Spread Formula

The Bid Ask Spread can be seen either as an absolute number or as a percentage.

For the calculation of the Bid Ask Spread, the analyst must know both the Bid and Ask prices posted by the market maker. The spread must be calculated with both prices at a particular time. The Bid price must be the highest price that an investor can sell at and the Ask price must be the lowest price that an investor can find to buy.

The formula to calculate the spread in absolute terms is simply the difference between the Bid and Ask Prices:

Bid Ask Spread = Ask Price – Bid Price

The formula to calculate the percentage of spread is the following:

% Bid Ask Spread = (Ask Price – Bid Price) / Bid Price

Let’s look at an example.

Bid Ask Spread Investing Examples

Example #1

Maria is a professional trader at a large brokerage firm, performing work for institutional clients such as hedge funds and proprietary trading organizations. As part of her job, she places trades for these clients, and is routinely asked about the spread for certain investments.

As she knows from experience, the bid ask spread depends widely on the liquidity, or availability, of the investment: a very liquid investment will have a low bid ask spread, whereas a very illiquid investment will have a large spread.

Currently, Maria is placing an order for Company, which is currently priced at $450 per share. Her client wants to know the bid-ask spread, so she looks at her data: the highest purchase price for a Company share is $455, where the lowest sell price for a Company share is $460.

In other words, the spread is $5, expressed as the spread divided by the lowest asking price, is (5/460) = 1.09%. This is a very low spread, which means a high liquidity for investors and an easier ability to buy and sell the stock.

Example #2

Let’s look at an example to understand how the Bid Ask Spread may be calculated. There are four stocks whose prices during Day X were the following:

Stock A

  • Bid Price = $1.00
  • Ask Price= $1.05

Stock B

  • Bid Price = $1.11
  • Ask Price = $1.15

Stock C

  • Bid Price = $0.81
  • Ask Price = $0.85

Stock D

  • Bid Price = $10.42
  • Ask Price = $11.07

For each one, the formula to calculate % Bid Ask Spread is applied.

Stock A

% Bid Ask Spread = (1.05 – 1.00) / 1.00 = 0.05 / 1.00 = 5%

Stock B

% Bid Ask Spread = (1.15 – 1.11) / 1.11 = 0.04 / 1.11 = 3.6%

Stock C

% Bid Ask Spread = (0.82 – 0.81) / 0.82 = 0.01 / 0.81 = 1.2%

Stock D

% Bid Ask Spread = (11.07 – 10.42) / 11.07 = 0.65 / 10.42 = 6.2%

An investor decided to buy 100 shares of Stock A, 50 shares of Stock B, 150 shares of Stock C and 200 shares of Stock D. He paid the Ask Price in each case.

He did not pay brokerage fees as the broker was a friend of him and did the work without charges. The very same day he wanted to sell them all because he changed his mind. The prices at that moment were:

Stock A

  • Bid Price = $1.00
  • Ask Price= $1.05

Stock B

  • Bid Price = $1.14
  • Ask Price = $1.18

Stock C

  • Bid Price = $0.81
  • Ask Price = $0.85

Stock D

  • Bid Price = $10.42
  • Ask Price = $11.07

He had to sell Stock A’s 100 shares at the Bid Price which was $1.00, so he lost money. The investor thought that he would not lose money with the Stock B, because its price slightly increased since the purchase. However, the Bid price was $1.14, still lower than the $1.15.

How to Interpret Bid Ask Spread Analysis

The higher the asset’s liquidity the lower the Bid Ask Spread or, said in other words, the lower the transaction cost. In contrast, the lower the asset’s liquidity, the higher the Bid Ask Spread. This means that the trading volume does impact the size of the spread and therefore, the transaction cost.

Highly efficient markets usually offer low bid-ask spreads, as their liquidity reduces the risk carried by market makers. On the other hand, securities that are traded Over The Counter (OTC) are usually less liquid and they commonly have larger spreads.

When an investor buys an asset at the Ask price, he considers the existence of the spread in his expectations. He expects that the market price will increase over the current Ask price, which is higher than the current Bid price. If this scenario comes true, the investor can get a profit after selling the asset. If not, he will either break-even or lose money on the transaction.

Bid-Ask Spread Limits and Cautions

 Bid Ask Spreads may widen during difficult times. Market makers enlarge the spreads as a strategy to protect their investments under severe market downturns. In other words, the percentage of Spreads is not necessarily stable from one period to another, even for very liquid assets.

Summary Definition

Define Bid Ask Spreads: Bid-Ask spread means the amount that the bid price of an asset exceeds the ask price of that investment in the marketplace.

Frequently Asked Questions

What does a narrow bid-ask spread signify about a stock’s market?

A narrow bid-ask spread indicates high liquidity in the stock, suggesting that it can be bought or sold easily without a significant impact on its price due to the close proximity of buying and selling prices.

How does the bid-ask spread affect an investor’s trading cost?

The bid-ask spread directly impacts trading costs, with a wider spread increasing the cost for investors as they must pay more above the market price to buy (ask) and accept less below the market price to sell (bid).

Can the bid-ask spread provide insights into market volatility?

Yes, a widening bid-ask spread often signals increased market volatility or uncertainty, as market makers demand greater compensation for the risk of providing liquidity in less stable conditions.

Why might the bid-ask spread vary significantly across different securities?

The bid-ask spread varies across securities due to differences in liquidity, trading volume, and market participant interest, with less frequently traded or more niche securities typically exhibiting wider spreads.

What implications does a high bid-ask spread have for traders?

A high bid-ask spread indicates lower liquidity and potentially higher volatility, making it more costly for traders to enter or exit positions quickly without impacting the market price.

How does a low bid-ask spread benefit investors?

A low bid-ask spread signifies high liquidity and less cost for investors to buy or sell the security, facilitating smoother and more cost-effective transactions.

error: Content is protected !!