DEFINITION of Proportional Spread
Proportional spread is a measure of a security's liquidity that is calculated by comparing the bid and ask prices quoted in the marketplace. The proportional spread is higher as trading liquidity of the security decreases to compensate the dealer for the additional risk of creating a market in an illiquid security. Also referred to as a proportional bid-ask spread.
The proportional spread is calculated as the difference between closing ask and bid prices divided by the average price of the bid and ask.
Proportional Spread = Ask - Bid / (Ask + Bid) ÷ 2
Ask = Highest close in month
Bid = Lowest close in month
BREAKING DOWN Proportional Spread
The proportional spread is used to give an idea of the average round-trip transaction compensation to dealers. The average transaction cost to the investor is calculated as one-half of the proportional spread. In general, proportional spreads can range from less than 0.5% to over 3%. For example, the average proportional spread on the New York Stock Exchange was 0.6% in the early 2000s, but the growth of electronic trading platforms, which has increased efficiency of the market-making process, has helped to shrink the average proportional spread to less than 0.2%. Note that this is the average figure; for highly liquid issues, with millions or even tens of millions of shares changing hands each trading session, the proportional spread can be just a few basis points. On the other hand, for names that trade with little volume or infrequently, the proportional spread will be much higher. Another factor that could influence a proportional spread is the size of the lot - a block trade, for instance, would be subject to a lower spread, while an odd lot trade would call for a higher one.
The proportional spread amount matters to the investor because it will add to his or her net cost basis of purchased shares or eat into net proceeds of sold shares. However, as pointed out previously, for liquid names, the cost of the trade will be de minimus.