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).
Market makers, many of which may be employed by brokerages, offer to sell securities at a given price (the ask price) and will also bid to purchase securities at a given price (the bid price). When an investor initiates a trade they will accept one of these two prices depending on whether they wish to buy the security (ask price) or sell the security (bid price). The difference between these two, the spread, is the principal transaction cost of trading (outside commissions), and it is collected by the market maker through the natural flow or processing orders at the bid and ask prices. This is what financial brokerages mean when they state that their revenues are derived from traders "crossing the spread."
The bid-ask spread can be considered a measure of the supply and demand for a particular asset. Because the bid can be said to represent demand and the ask to represent the supply for an asset, it would be true that when these two prices expand further apart the price action reflects a change in supply and demand.
The depth of the "bids" and the "asks" can have a significant impact on the bid-ask spread. The spread may widen significantly if fewer participants place limit orders to buy a security (thus generating fewer bid prices) or if fewer sellers place limit orders to sell.
Market makers and professional traders who recognize imminent risk in the markets may also widen the difference between the best bid and the best ask they are willing to offer at a given moment. If all market makers do this on a given security, then the quoted bid-ask spread will reflect a larger than usual size. Some high-frequency traders and market makers attempt to make money by exploiting changes in the bid-ask spread.
- 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 spreads can also reflect the market maker's perceived risk in offering a trade. For example, options or futures contracts may have bid-ask spreads that represent a much larger percentage of their price than a forex or equities trade. The width of the spread might be based not only on liquidity, but on how much the price could rapidly change.
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— t he most popular being foreign exchange and commodities.