One of the basic concepts of investing is the bid-ask spread, which can be used in different facets of a person's financial life, from buying a home or car. It can even be used to negotiate the purchase of stocks.
The bid-ask spread is very important in the marketplace. It's the difference between the buyer's and seller's prices—or what the buyer is willing to pay for something versus what the seller is willing to get in order to sell it.
In this short article, we look at what determines the bid-ask spread for a stock.
What Is a Bid-Ask Spread?
Let's first take a look at the basics of the bid-ask spread.
Stock exchanges are set up to assist brokers and other specialists in coordinating bid and ask prices. The bid price is the amount a buyer is willing to pay for a particular security, while the asking price is the amount a seller will take for that security.
If the prices are close together, it means the two parties have a similar opinion. On the other hand, if the price difference is wider, that means they don't see eye-to-eye.
But in reality, the asking price 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. This difference represents a profit for the broker or specialist handling the transaction.
This spread basically represents the supply and demand of a specific asset, including stocks. Bids reflect the demand, while the ask price reflects the supply. The spread can become much wider when one outweighs the other.
Liquidity Impact on Bid-Ask Spreads
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 number of shares 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.
Volatility and Bid-Ask 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—it. 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.
Stock Price Impact
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 small in size. Therefore, the number of these securities that can be traded is limited, making them less liquid.
Ultimately, the bid-ask spread comes down to supply and demand. That is, higher demand and tighter supply will mean a lower spread. Today, with the help of technology, finding a buyer or seller can be done much quicker, helping make supply-and-demand dynamics much more efficient.
Types of Orders
When a buyer or seller goes to place an order, there's a variety of orders that can be placed. This includes a market order, which, when placed, means the party will take the best offer. Then there's a limit order, which puts a limit on the price one is willing to pay to execute the transaction. A limit order will only be completed if that price is available. Meanwhile, a stop order is a conditional order, where it becomes a market or limit order when a particular price is reached. It can't be seen by the market otherwise, unlike a limit order, which can be seen when placed.
The bid-ask spread can say a lot about a security, meaning 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 may affect what bid-ask spread you find acceptable.
The Bottom Line
The spread between the bid and ask prices generally represents a form of negotiation between two parties—the buyer and the seller. There are many compounding factors that can affect how wide or narrow the spread is between the ask and bid price. By understanding the different factors, investors can make more informed decisions on their investments and limit their risk.