What Is Bid-Ask Spread?

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This spread is the transaction cost recorded as the trade exchange occurs and determines the stock’s liquidity. The wider the spread, the less liquid that stock tends to be.

Key Takeaways

  • The bid-ask spread refers to the transaction cost obtained when a stock’s bid price is subtracted from its ask price.The ask price is the lowest price of the stock at which the prospective seller is willing to sell the security they hold.The bid price is the highest price the prospective buyer is willing to pay for purchasing the security.The difference or spread is the profit for the market makers who initiate a trade for buyers and sellers.

Bid-Ask Spread Explained

A bid-ask spread is a basic concept trader must know when they enter the market to take trades. The market identifies a spread mainly when there is a misbalance in the supply and demand of the assets. This friction in the availability of assets affects their prices, narrowing or widening the difference between the bid and ask prices, termed a spread.

Brokers or market makers offer assets or securities with two price tags. They put the selling price, which is the ask price, for the asset, and the cost price, which is the bid price Bid Price Of The Same StockBid Price is the highest amount that a buyer quotes against the “ask price” (quoted by a seller) to buy particular security, stock, or any financial instrument. read more, for the same asset. The investors compare the prices and decide whether to buy or sell the stocks. Depending on their perspective of profit, they choose either of the two. However, no matter which bid-ask spread options they choose, the difference between the ask and bid prices would be the profit of the market makers who offer the deal.

Trading Strategies

The trading strategies must be known first to understand the bid-ask price meaning perfectly. Here, traders can take trades by placing their orders in two ways – market orders and limit orders. When the investors place the market order, they choose to purchase the stocks at the ask price. As the prices go up, investors observe the widening spread, thereby getting a room for more and more profits. Though this trading strategy works wonders in reaping trade profits for investors, it is essential that the market fluctuations boost the stock prices and do not affect them negatively.

In scenarios where the bid-ask spread widens significantly, investors might choose another option to book their trade profits. They can place a limit order, executed only when the prices of the assets fall below a certain limit. Investors can enter the trade at the entry-level to ensure they do not miss the chance to profit from the spread. They buy the security and sell the same when the prices move to the original ask price or above, which is always the figure below the bid price. This tends to be the best investment alternative for those with a set profit goal.

Influencing Factors

When traders calculate bid-ask spread, they obtain results for one stock share. Hence, the trade volume or the number of traded stocks is an important factor as it highly affects the results. The stocks that are thinly traded have higher spreads. This width of the spread is not constant, and it differs from one security to another, given how liquid the stocks are. The spread is low in a market with high liquidity and better trading volume as the number of traders, both buyers, and sellers, is higher.

Another factor that highly affects the bid-ask spread is market volatility. When the market undergoes frequent fluctuations, the spread widens.

Formula

The following bid-ask spread formula is used to make the required calculations:

Spread = Ask Price-Bid Price

Calculation Example

Let us take a practical bid-ask spread example to see how it works.

Tim decides to buy a few stocks with the savings he has. He thinks of investing in M Co’s stocks. Thus, he connects with his friend, Brown, a long-time investor who asks the former to find out the spread for the company beforehand. The investor knows that understanding the bid-ask spread could help Tim in future investments.

Thus, Brown provides the following details: –

  • The bid price (an assumed one) of a stock of M Co. is $100.The asking price (also an assumed one) of a stock of M Co. is $102.

Since Tim is a new investor, he does not understand the spread. So, he finds out the formula and applies it. And in one go, he calculates the spread of the stock of M Co. Here is his calculation: –

Spread = Ask price of a stock – Bid price of the same stock

= $102 – $100

= $2.

The spread of a stock of M Co. here is $2.

Importance

As stated above, the difference between ask and bid prices becomes the profit for those who sell the stocks. Hence, understanding how it is computed is an important aspect of trading. Furthermore, as the bid-ask spread helps assess market liquidity, booking profit at the right time becomes easier for investors.

For example, if the spread is small, it indicates that the market is stable, and the information about the stock prices offered for sale and purchase are almost similar. In such scenarios, the volume of securities available for trade is huge. On the other hand, if the spread is wider, it indicates a significant difference in the opinion of sellers and buyers. Plus, the volume of assets also remains limited.

Bid-Ask Spread Video

This article is a guide to What is a Bid-Ask Spread. Here, we explain its trading strategies, formula, calculation, example, factors, and importance. You may also look at the following articles to enhance your investing skills: –

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.

The narrower the spread, the higher the demand. It indicates the slight difference between the bid price and the ask price. On the contrary, the wider spread reveals the less liquid status of the market. The average spread for S&P 500 stocks is around 13% to 18%.

Investors purchase the stocks at the ask price. Then, they further sell it at a bid price. In this deal, the ask price is more than the bid price, which does not allow investors to enjoy this spread. Instead, the same becomes a transaction cost for the investors and profits for money makers or brokers.

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