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 to sell it.
BREAKING DOWN Bid-Ask Spread
The bid-ask spread is a reflection of the supply and demand for a particular asset. The bids represent the demand, and the asks represent the supply for the 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.
For 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.
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. Certain markets are more liquid than others. 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.
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 wide spread. Traders should use a limit order rather than a market order; meaning the trader should decide the entry point so that he doesn’t miss the spread opportunity. There is a cost involved with the bid-ask spread, as two trades are being conducted simultaneously. Finally, the bid-ask spread trades can be done in most kinds of securities — the most popular being foreign exchange and commodities.