This article will explain what a bid-ask spread is and provide helpful tips on how to handle them.
What is it?
A ‘bid-ask spread’ is the amount by which the asking price surpasses the bid price for a market asset. Basically, the bid-ask spread is the difference between the two types of prices:
- The highest price that a buyer is open to paying
- The lowest price that a seller is open to accepting
An individual that is wanting to sell will receive the bid price. Meanwhile, an individual who is looking to buy will pay the ask price.
Simply put, bid-ask spreads are essential when it comes to investors in the stock market.
Supply & Demand
Before moving forward, it is important to understand what ‘supply and demand’ entails. Not only for contextual purposes, but also for trading and investing as a whole. With this knowledge, you will be able to grasp the concept of spreads better.
Supply is in reference to the volume or abundance of a particular item in the marketplace. Such a thing can include the supply of a stock that is for sale. Demand is indicative of an individual’s general willingness to pay a specified price for an item or a stock.
The basic law of supply and demand is one of the most fundamental economic laws to ever exist. It ties into pretty much all economic principles in some way, shape, or form. In essence, supply and demand are two forces that pull against each other. They continue to do this up until the point where the market finds and obtains an equilibrium price. With that said, there are plenty of factors that can affect both supply and demand. This could lead to them either increasing or decreasing in a variety of ways.
Breaking it down
To further explain what a bid-ask spread is, we have to break it down to the bare essentials. Meaning we have to look into what components make up its name and
overall functionality.
A security’s price is the viewpoint of the market of its value at any given point in time. Moreover, it is its own unique thing. So, why exactly is there a “bid” and an “ask”? To properly understand this, one has to factor in the two prominent players in any market transaction. In other words, the price taker (or the trader) and the market maker (or the counter-party).
This is where the market maker – who is typically a financial brokerage – comes into play. They are responsible for spreading (bid – price – ask) the price for the security that the price taker transacts at. The spread is the cost of the transaction. Price takers purchase at the ask price and sell at the bid price. However, the market maker buys at the bid price and sells at the ask price. For the market maker, the paradigm of “buy low, sell high” for turning a profit is satisfactory.
This is the meaning behind financial brokerages’ statements of their revenues deriving from traders “crossing the spread.”
The bid-ask spread is indicative of the supply and demand concerning a specific asset. The bid embodies demand and the ask is representative of supply for an asset. The overall depth of both the “bids” and the “asks” can have a noticeable impact on the bid-ask spread. Thus, it results in significant expansion should one end up outweighing the other. Alternatively, if both are not prosperous. Market makers and traders make a profit by way of bit-ask spread exploitation. Additionally, the depth of bids and asks allows them to net the spread difference.
The relation to liquidity
Liquidity is a way to describe the degree to which an asset or security can be quickly bought or sold in the market. Moreover, when it is at a price that reflects its inherent value. To put simply, the ease of converting it to cash.
The overall size of the bid-ask spread from one asset to another tends to diverge. This is mainly due to the difference in the assets’ liquidity. The bid-ask spread is the most effective form of market liquidity measurement. There are some markets out there that are more liquid than others. There should be a reflection of that in their lower spreads. In a sense, transaction initiators (the price takers) demand liquidity, whereas counter-parties' (the market makers) are suppliers of liquidity.
Let’s take currency for an example. It is undoubtedly seen as the most liquid asset in the world. The bid-ask spread within the currency market, on the other hand, is one of the smallest; one-hundredth of a percent in fact. Strictly speaking, one can measure the spread in fractions of pennies. Conversely, assets with less liquid-like small-cap stocks – may possess spreads that equate to 1% or 2% of the asset’s lowest ask price.
Matching a spread
On the New York Stock Exchange (NYSE), it is possible for a buyer and seller to be matched by a computer. In a few instances, however, a specialist handling the stock in question matches buyers and sellers on the exchange floor. In times where there are no buyers and sellers, this person will post bids or offers for the stock. This will help preserve a systematic market.
On the NASDAQ stock market index, a market maker will utilize a computer system to post bids and offers. They basically play a role that is quite similar to a specialist. Despite this, there is no physical floor, so the marking of the orders is entirely electronic.
Common elements
There are several key elements that pertain to the bid-ask spread. First of all, a highly liquid market for any security. The point of this is to guarantee an ideal exit point to book a profit.
Second of all, there has to be some friction in the supply and demand for that security. This will allow it to effectively create a spread. Traders could then employ a limit order instead of a market order. The meaning behind this being that the trader should decide on the entry point. This way, it will make sure that they do not miss the spread opportunity. There is a cost with the bid-ask spread, though, as there is the simultaneous execution of two trades.
The final element is that bid-ask spread trades can be done in almost any kind of security. Probably the most popular of these securities is foreign exchange and commodities.
A handy example
As is the case with the exploration of most concepts and methods, we need to provide an example of how it works.
In this hypothetical scenario, let’s assume that the bid price for a stock is $19. Moreover, let’s imagine that the ask price for that same stock is $20. In this case, the bid-ask spread for the stock in question comes out to being $1. It’s possible to state the bid-ask spread in percentage terms. It is customary for the calculation to view it as a percentage of either the lowest sell price or ask price.
For this stock, the bid-ask spread in percentage terms would be calculated as $1 divided by $20. In other words, the bid-ask spread divided by the lowest ask price. This will yield a bid-ask spread of 5% ($1 / $20 x 100). This spread will close if there is an offer by a potential buyer to purchase the stock at a higher price. Alternatively, if a potential seller makes an offer to sell the stock at a much lower price.
Tips for bid ask spreads
There are a handful of tips that one should take into consideration when it comes to bid-ask spreads.
Tip #1 – Employ the use of limit orders
In most cases, an investor or trader is better off utilizing limit orders. This allows for a price limit for the purchase or sale of a security, instead of market orders. These are the ones that are filled at the market price that is triumphant. In markets that function at a faster pace, using market orders can lead to a higher price than the desirable price for purchases. Not only that but also a substantially lower price for sales.
For instance, let’s assume that the prevailing price of a security you are looking to buy is $9.95 / $10. In this case, you may consider bidding $9.97 for it rather than purchasing the stock at $10. Admittedly, the risk of a stock going up in price negates the possibility of acquiring the stock 3 cents cheaper. Nevertheless, you are still able to adjust your bid price if there is a requirement to do so. At least then you won’t be purchasing the stock at $10.05 because you entered a market order and the stock meanwhile went up.
Tip #2 – Keep watch for and evade liquidity charges
The application of limit orders enhances the levels of liquidity within the marketplace. This will allow you to avoid the liquidity charges that most electronic communication networks (ECNs) impose for using market liquidity. This typically occurs whenever you use market orders that experience execution at the bid and ask prices that prevail.
The ECN is a computerized system. Its purpose is to match buy and sell orders for securities that exist in the market. It links up major brokerages with individual traders so that they can trade directly between each other. They can do so without needing to go through a middleman. Additionally, make it conceivable for investors all over the globe to quickly and effortlessly trade with one another.
Tip #3 – Determine spread percentages
On the whole, bid-ask spreads have the potential to be quite significant if you are utilizing margin or leverage. It would be smart for you to evaluate the spread percentage. This is because a 5-cent spread on a $10 stock is much greater in percentage terms. Especially when you compare it to that of a 5-cent spread on a $40 stock.
Tip #4 – Shop around for spreads that are narrow
This tip is particularly relevant to retail forex traders. These individuals don’t usually have the luxury of the 1-cent spreads accessible to both interbank and institutional forex traders. You should look around for the narrowest spreads among the many forex brokers. Specifically, those who concentrate primarily on retail clientele. This way, you will improve your odds of a successful trade or two.
Conclusion
With all that has been said, it’s clear to see that investors ought to pay attention to the bid-ask spread. Above all else, it is a secret, concealed cost that trading any financial instrument can incur. Wide bid-ask spreads can deteriorate trading profits and provoke potential losses. One can mitigate the general impact of bid-ask spreads by following the four tips.
In a way, the bid-ask spread is a negotiation in progress. Are you a trader who strives for success? Then you must be willing to take a stand against the bid-ask process by way of limit orders. By conducting a market order without concern for the bid-ask, plus without limit insistence, traders are confirming another trader’s bid. Consequently, that trader receives a return.
