What Is a Bid-Ask Spread?

In trading, a bid-ask spread is the difference between the ask price and the bid price for an asset in the marketplace. It shows the highest price that a buyer is willing to pay for a security and the lowest price that a seller is willing to accept.

Anও individual looking to sell will accept the bid price🐲 while one looking to buy will pay the ask price.

Understanding Bid-Ask Spreads

The Bid and the Ask

A security's price is the market's perception of its value at any given point in 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 which may be employed by brokerages, offer to sell securities ꦺat a given price (the ask ♒price) and will also 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 Spread

The difference between these two, the spread, is the principal transaction cost of trading (outside of commissions). It is collected by the market maker through the natural flow of orders processed 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 number of bids and asks can have a significant impact on the bid-ask spread. The spread may widen significantly if fewer participants place limit orders ౠto buy a security (thus generating fewer bid prices) or if fewer sellers place limit 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. Biওd-ask spread trades can be transacted for most se👍curities, as well as foreign exchange and commodities.

Traders view the bid-ask spread as an indicator of market liquidity. High friction between the 澳洲幸运5官方开奖结果体彩网:supply and demand for a security will create a wider spread, reflecting a less liquid market for it. Most traders prefer to use 澳洲幸运5官方开奖结果体彩网:limit orders instead of market orders; this allows them to choose their own entry points rather than accepting the current market price. There i🃏s a cost involved with the bid-ask spread, as two trades are being conducted simultaneously.

Bid-Ask Spread Calculation

The bid-ask spread is calculated as the difference between the highest price that a buyer is willing to pay for a security and the lowest price that a seller🧸 is willing to accept.

Bid-Ask Spread = Ask Price - Bid Price

Beyond the Basic

While the basic calculation of the bid-as💝k spread involves pretty simple math, more complex calculations may be necessary. During dynamic, volatile markets, specific things may happen that make the spread not so straightforward. For example, in markets with multiple tiers of bids and asks, you might calculate a weighted average spread that takes into account the distribution of orders at different price levels.

You could also lean✅ on the effective spread. The effective spread accounts for the impact of market orders. This calculation is the difference between the execution price of a market order and the midpoint of the bid-ask spread. This can be a more accurate reflection of the true cost of trading, especially in highly liquid markets🅠.

You can also convert a bid-ask spread to a percentage spread if you prefer a comparative metric. For instance, if the bid-ask spread is $1 and a stock is trading at $50, a percentage spread of 2% ($1/$50) may have more meaning for you than the nominal amount of $1. 

Bid-Ask Spread and Liquidity

The bid-ask spread is the de facto measure of market 澳洲幸运5官方开奖结果体彩网:liquidity. Certain markets are 🃏more liquid than others, and that should be reflected in their narrow spreads.

A Reflection of Supply and Demand

Essentially, transaction initiators (price takers) demand liquidity while counterparties (market makers) supply liquidity. For example, currency is considered the most 澳洲幸运5官方开奖结果体彩网:liquid asset in the world, and the bid-ask spread in the currency market is one of the narrowest (one-hundredth of a percent); in other words, the spread can be measured in fractions of pennies. On the other hand, 澳洲幸运5官方开奖结果体彩网:less liquid assets, such as small-cap stocks, may have spreads that are equivalent to 1% to 2% of the asset's lowest ask 🌃pric💜e.

Perceived Risk

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 that represent a much larger 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.

Market Structure

Market structure 💮and competition among market participants also impacts the spread. In more competitive markets with numerous buyers and sellers, spreads tend to be tighter. For example, think of electronic markets that facilitate trades instantly. On the other hand, over-the-counter markets or less transparent markets thꦓat have fewer participants typically has wider spreads.

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 is $1. The bid-ask spread can also be stated in percentage terms; it is customarily c♏alculated as a percentage of the lowest sell price or ask price:

$1 ÷ $20 = 5%

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.

Factors That Impact the Bid-Ask Spread

Many things affect bid-ask spreads. The list below provides an overview of why bid-ask sp🍸reads exist and how they may cha𝐆nge. 

• Market Liquidity: Liquidity is the ease with which an asset can be bought or sold in the market without significantly impacting its price. Very generally speaking, highly liquid assets have narrower bid-ask spreads because there are more buyers and sellers willing to trade at or near the current market price.
• Volatility: Higher 澳洲幸运5官方开奖结果体彩网:volatility often leads to wider bid-ask spreads because it increases uncertainty in the market. Widening spreads mitigate potential losses from price fluctuations.
• Trading Volume: This goes hand in hand with liquidity. Higher trading volume typically results in narrower spreads as increased trading activity enhances market efficiency and reduces the impact of transaction costs. Part of the higher trading volume may be attributed to liquidity, though it could also signal a relatively illiquid stock simply being transacted a lot in a shorter period. 
• Asset Class: Different 澳洲幸运5官方开奖结果体彩网:asset classes can have different levels of liquidity and volatility which in turn impacts their spreads. For example, stocks of large, well-established companies often have narrower spreads compared to smaller, less-traded stocks. As you might expect, those larger-cap stocks with greater liquidity often have higher trading volumes. 
• Time of Day: Bid-ask spreads may vary throughout the trading day. Spreads may widen during slower times of the day or narrow during peak trading times. This also ties into alignment with external events. Consider how trading volume may change depending on the timing of a Federal Reserve meeting. 

Bid-Ask Spreads and Market Makers

Market makers play a part in how b📖id-ask spreads are formulated. They are able to make an impact because they:

• Provide Liquidity: Market makers continuously quote both bid and ask prices for securities, ensuring there are readily available prices at which traders can buy or sell. Market makers facilitate smooth and efficient trading, therefore reducing the bid-ask spread.
• Narrow Spreads: Market makers compete with each other to capture order flow by offering the best bid and ask prices. This competition often leads to tighter spreads as market makers strive to attract trades.
• Manage Risk: Market makers assume the risk of holding inventory in securities. They profit from the bid-ask spread, buying securities at the bid price and selling them at the ask price. To manage their risk exposure, market makers adjust their bid and ask prices based on factors such as market conditions, volatility, and inventory levels.
• Adapt to Market Conditions: Market makers continuously monitor 澳洲幸运5官方开奖结果体彩网:market conditions and adjust their quotes accordingly. During periods of high volatility or low liquidity, market makers may widen spreads to compensate for increased risk.
• Enhance Market Efficiency: Market makers enhance market efficiency by reducing price discrepancies between buyers and sellers. By providing competitive bid and ask prices, market makers help ensure that securities trade close to their fair market value.
• Support Order Flow: Market makers support 澳洲幸运5官方开奖结果体彩网:order flow by executing trades on both the buy and sell sides of the market. This helps maintain orderly trading and prevents large imbalances between buyers and sellers, which can lead to increased market volatility.
  

Bid-Ask Spread and Arbitrage

Traders who engage in 澳洲幸运5官方开奖结果体彩网:arbitrage look for oppor🐽tunities to profit from inefficiencies in the bid-ask spread, often by simultaneously buying and selling the same or related assets across different markets or platforms.

For example, if a stock is trading with a bid of $100 on one exchange and an ask of $99 on another (🧜perhaps due to time lags or fragmented markets), an arbitrageur could buy at $99 and sell at $100, locking in a $1 profit per share, minus transaction costs. These trades typically need to be executed quickly, as arbitrage opportunities tend to disappear rapidly once discovered and acted upon. Therefore, especially in thꦆis context, arbitrage is usually done leveraging technological tools.

Arbitrage involving the bid-ask spread isn't limited to price differences across venues. Traders also use algorithmic strategies like market making, where they post both bid and ask quotes and profit from capturing the spread itself. They can make this happen by managing order flow and adjusting quotes in response to market activity

The Bottom Line

The bid-ask spread serves as an effective measure of li🌃quidity, as more liquid securities will have narrow spreads while illiquid onesꦑ will have wider 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.

Correction—Dec. 4, 2022: This article’s question-and-answer segment was edited from a previous version that incorrectly defined bid-ask spread.