What are the determinants of a stock's bid-ask spread?

By Nicola Sargeant AAA
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.

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