What is a Bid-Ask Spread?
A bid-ask spread is the amount by which the ask price exceeds the bid price for an asset in the market. The bid-ask spread is essentially the difference between the highest price that a buyer is willing to pay for an asset and the lowest price that a seller is willing to accept. An individual looking to sell will receive the bid price while one looking to buy will pay the ask price.
Understanding Bid-Ask Spread
A securities price is the market's perception of its value at any given point in time and is unique. To understand why there is a "bid" and an "ask" one must factor in the two major players in any market transaction, namely the price taker (trader) and the market maker (counterparty).
The market maker, usually financial brokerages, spreads (bid - price - ask) the price for the security that the price taker transacts at. The spread is the transaction cost. Price takers buy at the ask price and sell at the bid price but the market maker buys at the bid price and sells at the ask price. For the market maker the buy low - sell high paradigm for turning a profit is satisfied. This is what financial brokerages mean when they state that their revenues are derived from traders "crossing the spread."
The bid-ask spread is a reflection of the supply and demand for a particular asset. The bid represents demand and the ask represents supply for an asset. The depth of the "bids" and the "asks" can have a significant impact on the bid-ask spread, making it widen significantly if one outweighs the other or if both are not robust. Market makers and traders make money by exploiting the bid-ask spread and the depth of bids and asks to net the spread difference.
- The bid-ask spread is essentially the difference between the highest price that a buyer is willing to pay for an asset and the lowest price that a seller is willing to accept.
- The spread is the transaction cost. Price takers buy at the ask price and sell at the bid price but the market maker buys at the bid price and sells at the ask price.
- The bid represents demand and the ask represents supply for an asset.
- The bid-ask spread is the de facto measure of market liquidity.
The Bid-Ask Spread's Relation to Liquidity
The size of the bid-ask spread from one asset to another differs mainly because of the difference in liquidity of each asset. The bid-ask spread is the de facto measure of market liquidity. Certain markets are more liquid than others and that should be reflected in their lower spreads. Essentially, transaction initiators (price takers) demand liquidity while counterparties (market makers) supply liquidity.
For example, currency is considered the most liquid asset in the world and the bid-ask spread in the currency market is one of the smallest (one-hundredth of a percent); in other words, the spread can be measured in fractions of pennies. On the other hand, less liquid assets, such as small-cap stocks, may have spreads that are equivalent to 1 to 2% of the asset's lowest ask price.
Bid-Ask Spread Example
If the bid price for a stock is $19 and the ask price for the same stock is $20, then the bid-ask spread for the stock in question is $1. The bid-ask spread can also be stated in percentage terms; it is customarily calculated as a percentage of the lowest sell price or ask price. For the stock in the example above, the bid-ask spread in percentage terms would be calculated as $1 divided by $20 (the bid-ask spread divided by the lowest ask price) to yield a bid-ask spread of 5% ($1 / $20 x 100). This spread would close if a potential buyer offered to purchase the stock at a higher price or if a potential seller offered to sell the stock at a lower price.
Elements of the Bid-Ask Spread
Some of the key elements to the bid-ask spread include a highly liquid market for any security in order to ensure an ideal exit point to book a profit. Secondly, there should be some friction in the supply and demand for that security in order to create a spread. Traders should use a limit order rather than a market order; meaning the trader should decide the entry point so that they don't miss the spread opportunity. There is a cost involved with the bid-ask spread, as two trades are being conducted simultaneously. Finally, bid-ask spread trades can be done in most kinds of securities — the most popular being foreign exchange and commodities.