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.
Key Takeaways
- A bid-ask spread is 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.
Bid-Ask Spread
Understanding Bid-Ask Spreads
A security's 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 of 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. The bid can be said to represent the demand for an asset and the ask represents the supply, so when these two prices move 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. As such, it's critical to keep the bid-ask spread in mind when placing a buy-limit order to ensure it executes successfully.
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'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 also on how quickly the prices could change.
Bid-Ask Spread Example
If the bid price for astock 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
Bid-ask spread trades can be done in most kinds of securities, as well as foreign exchange and commodities.
Traders use the bid-ask spread as an indicator of market liquidity. High friction between the supply and demand for that security will create a wider spread.
Most traders prefer to use limit orders instead of market orders; this allows them to choose their own entry points rather than accepting the current market price. There is a cost involved with the bid-ask spread, as two trades are being conducted simultaneously.
How Does Bid-Ask Spread Work?
In financial markets, a bid-ask spread is the difference between the asking price and the bidding price of a security or other asset. The bid-ask spread is the difference between the highest price a buyer will offer (the bid price) and the lowest price a seller will accept (the ask price). Typically, an asset with a narrow bid-ask spread will have high demand. By contrast, assets with a wide bid-ask spread may have a low volume of demand, therefore influencing wider discrepancies in its price.
What Causes a Bid-Ask Spread to Be High?
Bid-ask spread, also known as "spread", can be high due to a number of factors. First, liquidity plays a primary role. When there is a significant amount of liquidity in a given market for a security, the spread will be tighter. Stocks that are traded heavily, such as Google, Apple, and Microsoft will have a smaller bid-ask spread.
Conversely, a bid-ask spread may be high to unknown, or unpopular securities on a given day. These could include small-cap stocks, which may have lower trading volumes, and a lower level of demand among investors.
What Is an Example of a Bid-Ask Spread in Stocks?
Consider the following example where a trader is looking to purchase 100 shares of Apple for $50. The trader sees that 100 shares are being offered at $50.05 in the market. Here, the spread would be $50.00 - $50.05, or $0.05 wide. While this spread may seem small or insignificant, on large trades, it can create a meaningful difference, which is why narrow spreads are typically more ideal. The total value of the bid-ask spread, in this instance, would be equal to 100 shares x $0.05, or $5.
The Bottom Line
The bid-ask spread serves as an effective measure of liqudity, as more liquid securities will have small spreads while illiquid ones will have larger ones. Investors should keep an eye on the spread of any security they wish to buy or sell to get a sense for how frequently it trades and to decide on the type of order to use when making a transaction.
Correction—Dec. 4, 2022: This article’s question-and-answer segment was edited from a previous version that incorrectly defined bid-ask spread.
FAQs
What Is a Bid-Ask Spread, and How Does It Work in Trading? ›
In financial markets, a bid-ask spread is the difference between the asking price and the bidding price of a security or other asset. The bid-ask spread is the difference between the highest price a buyer will offer (the bid price) and the lowest price a seller will accept (the ask price).
What is an example of a bid-ask spread? ›For example, if a stock price has a bid price of $100 and an ask price of $100.05, the bid-ask spread would be $0.05. The spread can also be expressed as a percentage of the ask price, which in this case would be 0.05 percent.
How do you make money from bid-ask spread? ›How to profit from bid-ask spread? Traders buy stocks at the bid price and proceed to make those stocks available for the next set of investors. They offer the bid price (price to buy) and ask price (price for sale) for the stocks. The difference between the bid and ask prices becomes the profit for them.
Do I buy at the bid or ask? ›The term "bid" refers to the highest price a buyer will pay to buy a specified number of shares of a stock at any given time. The term "ask" refers to the lowest price at which a seller will sell the stock.
How do market makers make money off the bid-ask spread? ›Generally, market makers profit by charging higher ask prices (selling) than bid prices (buying). The difference is called the 'spread'. The spread compensates the market makers for the risk inherited in such trades which can be the price movement against the market makers' trading position.
What is the benefit of bid-ask spread? ›The bid-ask spread for a stock is the difference in the price that someone is willing to pay (the bid) and where someone is willing to sell (the offer or ask). Tighter spreads are a sign of greater liquidity, while wider bid-ask spreads occur in less liquid or highly-volatile stocks.
Why is bid-ask spread important? ›In contrast, a larger spread suggests lower liquidity, as there are fewer investors willing to negotiate. You can use the bid-ask spread to determine whether to place a market order or limit order when trading, helping you to optimize your price and have a successful order execution.
What is the best bid and best ask? ›The highest price that someone is willing to buy a crypto at is known as the “best bid“. This best bid price guarantees the highest possible price for any seller at that particular time. The lowest possible price that someone is willing to sell at is called the “best ask” or “best offer”.
What happens if bid is higher than ask? ›When the bid size is larger than the ask size, more orders to buy at a specific price are being placed compared to orders to sell at that same price.
Is a tight bid-ask spread good? ›A tight bid-ask spread can indicate an actively traded security with good liquidity. Meanwhile, a wide bid-ask spread may indicate just the opposite. If there is a significant supply or demand imbalance and lower liquidity, the bid-ask spread will expand substantially.
Do day traders buy at bid or ask? ›
Day traders will feel the full impact of the current spread when they use the market order function. Market orders are filled at the most favorable opposing price, bid for sellers and ask for buyers, until the entire quantity of the order is filled.
Can you buy a stock below the ask price? ›Limit Order. A trader who wants to buy a stock instantly must place a market order and pay the ask price. However, a buyer who is willing to be patient can place a limit order and set a specified price below the current ask price at which they are willing to buy the stock.
Do you sell at bid or offer price? ›The bid price is the amount of money a buyer is willing to pay for a security. It is contrasted with the sell (ask or offer) price, which is the amount a seller is willing to sell a security for. The difference between these two prices is referred to as the spread.
How do traders make money on spreads? ›Spread trading is a trading method that consists of opening two opposite positions, a long (buy) and a short (sell) on two related assets with predetermined amounts. This way, your market position remains neutral, and potential profits depend only on the price difference (the spread) between the two assets.
Do market makers set the bid and ask? ›Key Takeaways
The market-maker spread is the difference in bid and ask price set by the market makers in a particular security. Market makers earn a living by having investors or traders buy securities where MMs offer them for sale and having them sell securities where MMs are willing to buy.
Market Makers subject to the Aggregate Indebtedness Requirement maintain minimum net capital that is the greater of: $100,000. $2,500 for each security that it is registered as a Market Maker (unless a security in which it makes a market has a market value of $5 or less.
What is an example of bid and ask price? ›The bid-ask spread works to the advantage of the market maker. Continuing with the above example, a market maker who is quoting a price of $10.50 / $10.55 for ABC stock is indicating a willingness to buy A at $10.50 (the bid price) and sell it at $10.55 (the asked price).
What are the three components of bid-ask spread? ›There are three main components of the bid-ask spread. The order processing cost which is associated with the cost of providing liquidity, the inventory cost that is due to short-term order imbalances and the adverse selection cost that refers to the cost of trading with informed traders.
What is bid-ask price example options? ›For example, the mark price for an options contract with a $2.00 bid and a $2.10 ask would be $2.05. The benefit of the mark price is that you'll pay less (if you're a buyer) or get more (if you're a seller). However, your order has less of a chance of getting filled.
What is considered a tight bid-ask spread? ›A tight bid-ask spread can indicate an actively traded security with good liquidity. Meanwhile, a wide bid-ask spread may indicate just the opposite. If there is a significant supply or demand imbalance and lower liquidity, the bid-ask spread will expand substantially.