The bid-ask spread is the difference between the highest offered purchase price and the lowest offered sales price for a security. Brokers often quote the spread as a percentage, calculated by dividing the bid/ask difference by either the midpoint or ask. In the case of equities, these prices represent the demand and supply for shares in the stock market. The primary determinant of bid-ask spread size is trading volume. Thinly traded stocks tend to have higher spreads. Market volatility is another important determinant of spread size. Spreads usually widen in times of high volatility.

Key Takeaways

  • The bid-ask spread is the difference between the highest offered purchase price and the lowest offered sales price.
  • Highly liquid securities typically have narrow spreads, while thinly traded securities usually have wider spreads.
  • Bid-ask spreads usually widen in highly volatile environments.
  • Traders can manage stocks with wide spreads by using limit orders, price discovery and all-or-none orders.

Trading Volume

Trading volume refers to the number of shares that exchange hands during a given period, measuring the liquidity of a stock. High-volume securities such as index exchange-traded funds (ETFs) or large-cap firms, such as Microsoft Corporation (MSFT) or General Electric Company (GE), are highly liquid with narrow spreads. Many investors look to buy or sell shares of these companies at any given time, making it easier to locate a counterparty for the best bid or ask price.

Stocks with low volumes usually have wider spreads. Small companies frequently exhibit a lower trading volume because fewer investors are interested in relatively unknown firms. Market makers often use wider bid-ask spreads on illiquid shares to offset the risk of holding low volume securities. They have a duty to ensure efficient functioning markets by providing liquidity. A wider spread represents higher premiums for market makers.

Volatility

Volatility measures the severity of price changes for a security. When volatility is high, price changes are drastic. Bid-ask spreads usually widen in highly volatile environments, as investors and market makers attempt to take advantage of agitated market conditions.

How to Trade Stocks with Wide Bid/Ask Spreads

Use Limit Orders: Instead of blindly entering a market order for immediate execution, place a limit order to avoid paying excessive spreads. Let’s assume David wants to purchase a small-cap stock and the best bid is 30 cents, while the best offer is 50 cents. David could enter a buy limit order at 31 cents, which sits at the top of the bid giving him priority over all other buyers. Alternatively, if David was a seller, he could place a sell limit order at the top of the offer at 49 cents.

Price Discovery: Often, stocks that have wide spreads trade infrequently. Even if a trader uses limit orders, they can sit on the bid or ask for days without getting executed. Test out the market by incrementally increasing the buy limit price and decreasing the sell limit price. For example, If Emily currently sits at the top of the bid at $1.00 and the best offer is $1.25, she could perform price discovery by raising her limit order by 5 cents each day for a week to test the willingness of a seller to come down to her bid price. 

Avoid All-or-None Orders: These orders specify that the total number of shares bought or sold gets executed, or none of them do. In wide bid/ask markets, liquidity is often thin, meaning a trader could miss out on acquiring shares if only small parcels of stock get traded. For instance, if Tom has placed an all-or-none buy limit order for 5,000 shares at $1.00 and a seller enters the market with 4,999 shares to offload at the bid price, the trade wouldn't execute due to a shortage of units to fill Tom's order in its entirety i.e., one share short.