The bid-ask spread is the difference between the highest offered purchase price and the lowest offered sales price for a security. The spread is often presented as a percentage, calculated by dividing the difference between the bid and ask by either the midpoint or the 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 grow in times of high volatility.
Trading volume refers to the number of shares of a stock that are traded in a given time period and measures the liquidity of a stock. High-volume securities such as popular exchange-traded funds (ETFs) or very large firms including Microsoft or General Electric are highly liquid, and the spreads are usually only a few cents. Many investors are looking to buy or sell shares of these companies at any given time, so it is easier to locate a counterparty for the best bid or ask price.
Stocks with low volumes usually have wider spreads. Small companies frequently exhibit lower trading volume because fewer investors are interested in relatively unknown firms. Large bid-ask spreads on illiquid shares are also used by market makers to compensate themselves for assuming the risk of holding low-volume securities. Market makers have a duty to engage in trading to ensure efficiently functioning markets for securities. A wide spread represents a higher premium for market makers.
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.