Bid-ask spread is an amount by which the asset’s ask price is more than the bid price in the market. It is the difference between the highest amount a buyer wishes to pay for an asset and the lowest price that the seller accepts. It can be understood as a measure of the supply and demand for an asset.
This bid-ask spread formula is affected by various factors like liquidity, volatility, etc. The ‘bid’ is associated with demand and the ‘ask’ is related to supply for the assets. The one looking to sell receives the bid price, while the one looking to buy pays the price.
What is Bid-Ask Spread?
Definition: The bid-ask spread is defined as the difference between the ‘bid’ price and the ‘ask’ price of a stock. It is also used for buying security at the best price. Bid-ask spread is responsible for affecting the stock’s price at which a sale or purchase is made in the market and thus it influences the overall portfolio return of an investor.
Bid-Ask Spread is the de facto measure of the liquidity of the market. As mentioned above- The ‘bid’ represents the demand, ‘ask’ the supply of an asset, and ‘spread’ denotes the transaction cost. The bid-ask spread largely depends on the liquidity—the more the liquid stock, the tighter the spread.
Understanding Bid-Ask Spread
Bid-ask spread is the difference between the highest bid price quoted by a buyer and the lowest price that a seller likes to accept in financial markets.
Investors need to understand the concept of supply and demand before indulging in the ins and outs of spread. The volume or abundance of a particular item in the marketplace is referred to as supply. Demand is the wish of an individual to pay a specific price for an item or stock. The bid-ask spread is also the signal of levels where buyers buy and sellers sell. A tight bid-ask spread with good liquidity indicates active trade security.
The Bid-ask spread expands when there is a noticeable imbalance in supply or demand and liquidity is low. So, popular securities like Google or Apple stock have a low spread while not-readily traded stock will have a wider spread.
All in all, particular security that has a narrow bid-ask spread enjoys high demand while security that has a wide bid-ask spread might have a low volume of demand, therefore influencing wider discrepancies in its price.
Two main players that channelize any market transactions are price takers (trader) and market makers (counterparty). Market makers make offers for selling securities at the ‘ask’ price, plus they also bid for purchasing trade securities at the ‘bid’ price in the stock market. When a trader initiates a trade, these market makers accept one of these two prices (if they like to buy the security, it would be the ‘ask’ price, and if they’d like to sell the security, the price would be ‘bid’ price).
This difference between these two prices is understood as the spread which will also be the main transaction cost of trading (outside commissions) that market makers collect via the natural flow of processing orders.
The Bid Price
The price that an investor likes to pay for the security is understood as the current ‘bid’ price. For instance, in case an investor likes to sell a stock, it would be essential for him or her to find out the amount someone is willing to pay for the stock. This amount is the bid price that is actually the highest price that someone likes to pay.
The Ask Price
The price for which an investor likes to sell the security is understood as the ‘ask’ price. For instance, if you want to buy a stock, you should try to find out how much someone likes to sell it for. You would like to find out the ‘ask’ price which is actually the lowest price someone likes to sell the stock for.
Types of Bid-Ask Spread
1. Quoted spread
It is the most basic type of bid-ask spread is the quoted spread that is directly related to the quotes or the posted prices. It is also understood as the average between the lowest ask and the highest bid. The quoted bid-ask spread formula is-
2. Effective spread
In the quoted spreads, there may occur the over-stating of the spreads finally paid by traders. This issue is resolved by effective spreads by using trade prices.
3. Realized spread
Both the aforementioned spreads are associated with the costs incurred by traders which are the cost of asymmetric information and the cost of immediacy. But in the realized spread, the cost of immediacy is isolated. Its formula is-
Examples of Bid-Ask Spread
The impact on the bid-ask spread is mostly not noticed by the investors if they are trading in high profile. Trading high profile is defined by highly liquid stocks, with tighter bid-ask spreads. The Bid-ask spread doesn’t impact the buyers and sellers.
The bid-ask spread with 3 Million companies is taken as an example. It is supposedly a highly traded large-capitalization stock. The bid-ask price changes all the time. In a current glimpse, the stock’s bid is at $189.24, and the ask is at $189.28. The difference is four cents and is the bid-ask spread.
Stocks that are with low liquidity, supposedly, have a stock that doesn’t trade often. The stock not indulging in the trade has a bid of 9$ per share and an ask of $10.50 per share. The wider spread is $1.50
How the Bid-Ask Spread is Matched?
A buyer and seller can be matched by a computer on the New York Stock Exchange.
In some instances, the specialist handles the stock who matches the sellers and buyers on the exchange floor.
A specialist is a person who can put bids or offers for the stock on behalf of buyers and sellers in their absence. It helps in maintaining an orderly market.
Types of Orders
An individual can place five types of orders with a specialist or market maker.
1. Limit Order
A limit order is placed to buy a certain stock at a specific given price. Investors need to pay attention to the fact that if they endeavor to buy, then the asking price and the bid price will fall to the limit order price level. The cost can also be below so that the order is fulfilled.
2. Day Order
A day order is only meant for that particular trading day. If the order is not filled on that day, the order stands canceled.
3. Stop Order
When the stock passes a certain level, the Stop Order comes into the picture. For instance, if an investor means to sell 1000 shares of a particular stock at its trade down to $9. In that case, the investor gets a facility to put a stop order at $9. It will help make the order effective as a market order when the stock comes up to that level.
4. Market Order
It is filled at the market or prevailing prices. For example, if the buyer orders to buy 1500 shares, the buyer will receive 1500 shares. The asking price of 1500 shares will be $10.25. If they place the market order for 2000 shares, the buyer will receive 1500 shares at the asking cost of $10.25. The remaining 500 shares will be given at the next best offer price, which might be higher than $10.25.
5. FOK Order
FOK Order, also known as Fill or Kill order, is immediate to be filled in its entirety or not to be filled at all. For instance, if a person puts the order of fill or kills for 2000 shares at $10, the buyer will immediately take in all the shares or refuse it. The refusal of the order makes the order stand canceled.
The bid-ask spread is a negotiation process. If the bid-ask spread is more expansive, the liquidity is less for the financial instrument. The liquidity is more when the bid-ask spread is narrower.
The difference between the bid and ask, whether large or small, is affected by the prices of shares and primarily by volume. It is also one of the most effective ways to measure the supply and demand for a particular commodity.
How important do you consider the role of bid-ask spread in the market?