Although bid-ask spread and bid-ask bounce relate to the bid price and ask price of a stock or other investment, the two terms refer to completely different concepts. The bid-ask spread is the difference between the bid price and ask price. It also represents the basic transaction cost that applies to trading an investment. The bid-ask bounce refers to a very specific condition of volatility and reflects the price movements between the bid and ask.
Most financial markets today—forex, options, futures, stocks—are organized so that investors can quickly see the latest prices or quotes. A quote includes the bid price and the ask price. The bid price is the highest price point where buyers are ready to buy. The asking price is the lowest price at which sellers are willing to sell a stock or other investment asset. It is also known as the offering price.
- The bid price is the highest possible price that buyers in the market are willing to pay and the ask price is the lowest possible price that sellers are ready to receive.
- A quote includes both the bid price and ask price.
- The spread between the bid and the ask represents a cost of doing business when investors buy and sell.
- Active and liquid markets typically have smaller bid-ask spreads when compared to thin or illiquid markets.
- The bid-ask bounce refers to the price movements between the bid and ask, which can suggest that prices are moving when, in fact, the quote has not changed.
The bid-ask spread is the difference between the bid and ask prices. For example, if the bid price of a stock is $50 and the ask price is $51, the spread equals $1. The size of the spread varies depending on the instrument and is often viewed as an indicator of trading liquidity, with highly liquid and active markets typically seeing smaller bid-ask spreads and less liquid or thin markets with wider bid-ask spreads.
Traders pay close attention to the bid-ask spread because it can represent a significant hidden transaction cost. Although the spread is not a specific fee that traders are charged, it is a source of revenue to the market maker and part of the cost of trading to the investor. Obtaining good spreads can significantly increase a trader's profit margin, whereas trading with excessive spreads can offset much of a trader's net gains. In short, the bid-ask spread, along with commissions or other fees, represents a basic transaction cost of trading in most financial markets today.
The bid-ask bounce is a specific situation when the price of a stock or other asset bounces back and forth within the very limited range between the bid price and ask price. This happens when there are trades on both the bid and asking price, but no real movement in price. The bounce can also occur when the bid price jumps to become equal to what the selling price was just a moment before, but then drops back to its original level.
Using the previous bid-ask example, the bid price would bounce very quickly back and forth between $50 and $51. Now, say this happens for several hours during the trading day, with the price moving between $50 and $51. The quote does not necessarily change and so there is no real movement in the price. However, a $1 move on a $50 stock represents 2%.
Therefore, while it may appear that the stock is moving 2% when it moves between a $50 bid and a $51 ask, it is not moving at all if one looks at the mid-market price (the average of the bid and ask) of $50.50 per share. That's why some traders look at the size of the bid-ask bounce when attempting to gauge the true volatility of a stock or other investment.