A:

Stock exchanges are set up to assist brokers and other specialists in coordinating bid and ask prices. The bid price is the amount that a buyer is willing to pay for a particular security; the ask price is the amount that a seller wants for that security - it is always a little higher than the bid price. The difference between the bid and ask prices is what is called the bid-ask spread and this difference represents a profit for the broker or specialist handling the transaction.

There are several factors that contribute to the difference between the bid and ask prices. The most evident factor is a security's liquidity. This refers to the volume or amount of stocks that are traded on a daily basis. Some stocks are traded regularly, while others are only traded a few times a day. The stocks and indexes that have large trading volumes will have narrower bid-ask spreads than those that are infrequently traded. When a stock has a low trading volume, it is considered illiquid because it is not easily converted to cash. As a result, a broker will require more compensation for handling the transaction, accounting for the larger spread.

Another important aspect that affects the bid-ask spread is volatility. Volatility usually increases during periods of rapid market decline or advancement. At these times, the bid-ask spread is much wider because market makers want to take advantage of - and profit from - the change. When securities are increasing in value, investors are willing to pay more, giving market makers the opportunity to charge higher premiums. When volatility is low and uncertainty and risk are at a minimum, the bid-ask spread is narrow.

A stock's price also influences the bid-ask spread. If the price is low, the bid-ask spread will tend to be larger. The reason for this is linked to the idea of liquidity. Most low-priced securities are either new or are small in size. Therefore, the number of these securities that can be traded is limited, making the them less liquid.

The bid-ask spread can say a lot about a security and, therefore, you should be aware of all the reasons that are contributing to the bid-ask spread of a security you are following. Your investment strategy and the amount of risk that you are willing to take on may affect what bid-ask spread you find acceptable.

For further reading, see Why The Bid-Ask Spread Is So Important.

RELATED FAQS
  1. What are some examples of general and administrative expenses?

    In accounting, general and administrative expenses represent the necessary costs to maintain a company's daily operations ... Read Full Answer >>
  2. How do dividend distributions affect additional paid in capital?

    Whether a dividend distribution has any effect on additional paid-in capital depends solely on what type of dividend is issued: ... Read Full Answer >>
  3. Why can additional paid in capital never have a negative balance?

    The additional paid-in capital figure on a company's balance sheet can never be negative because companies do not pay investors ... Read Full Answer >>
  4. When does the fixed charge coverage ratio suggest that a company should stop borrowing ...

    Since the fixed charge coverage ratio indicates the number of times a company is capable of making its fixed charge payments ... Read Full Answer >>
  5. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  6. How can I find net margin by looking a company's financial statements?

    In finance and accounting, financial statements represent the fundamental means of analyzing a company's financial position, ... Read Full Answer >>
Related Articles
  1. Fundamental Analysis

    Calculating Return on Net Assets

    Return on net assets measures a company’s financial performance.
  2. Economics

    Understanding Cost of Revenue

    The cost of revenue is the total costs a business incurs to manufacture and deliver a product or service.
  3. Economics

    Explaining Carrying Cost of Inventory

    The carrying cost of inventory is the cost a business pays for holding goods in stock.
  4. Investing

    How To Calculate Minority Interest

    Minority interest calculations require the use of minority shareholders’ percentage ownership of a subsidiary, after controlling interest is acquired.
  5. Economics

    Explaining Replacement Cost

    The replacement cost is the cost you’d have to pay to replace an asset with a similar asset at the present time and value.
  6. Economics

    How Does National Income Accounting Work?

    National income accounting is an economic term describing the system used by a country to gather data and determine aggregate economic activity.
  7. Fundamental Analysis

    Understanding the EBITDA/EV Multiple

    The EBITDA/EV multiple is a financial ratio that measures a company’s return on investment.
  8. Term

    What is Wealth Management?

    Wealth management combines financial and investment advice, accounting and tax services, and legal and estate planning.
  9. Personal Finance

    AR & Inventory Turnover Is Key For These Sectors

    Accounts receivable and inventory turnover are two important ratios in the current asset category. We will also discuss the key industries that benefit from a thorough understanding of these ...
  10. Economics

    Explaining Double Entry Accounting

    Double entry is an accounting and bookkeeping term describing the method of entering transactions into the accounting records.
RELATED TERMS
  1. Receivables Turnover Ratio

    An accounting measure used to quantify a firm's effectiveness ...
  2. International Financial Reporting Standards - IFRS

    A set of international accounting standards stating how particular ...
  3. Days Sales Outstanding - DSO

    A measure of the average number of days that a company takes ...
  4. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis ...
  5. Surplus

    The amount of an asset or resource that exceeds the portion that ...
  6. Cash Flow

    The net amount of cash and cash-equivalents moving into and out ...

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!