
When it comes to stock markets and trading, you will come across thousands of jargon that tend to get confusing. With your money on the line, it becomes important to understand the nuances of the market and its working in detail.
One such commonly used term in trading is the “Bid-ask spread.” This term holds a lot of significance for stock market investors; however, many don’t seem to gauge its meaning correctly. Not knowing what a bid-ask spread entails the potential risk of hampering an investor’s overall portfolio. As bid-ask spread can have an effect on the prices at which purchases and sales are made, it is vital to understand it in depth.
What Does A Bid-Ask Spread Mean?
A bid-ask spread is mainly the difference between the highest amount that a buyer is offering to pay for any market asset and the last (lowest) price that a seller is willing to agree upon. It is the amount by which an ask price for an asset exceeds the bid price. If you are looking to buy an asset, you will be paying the ask price of it. While if you want to sell an asset, you will get the bid price.
Bid-Ask Spread In Depth
The market’s idea of its value at a given point in time, which is unique for every instance, is called a Security Price. If you wish to learn the reason why you find a “bid,” followed by an “ask,” you need to take into account two major key players in trading. These are namely the trader (price taker) and the opposite/counterparty (market maker).
A lot of the market makers who also double up as brokerage employees tend to sell a commodity (securities) at an ask price. They can also bid or offer to buy a commodity at a bid price.
When a trade is initiated by an investor, he/she can choose to either sell the commodity (the bid price) or acquire the commodity (the ask price). This difference between the two prices, which is also the transaction cost (without commissions), is known as the Spread.
Spreads are taken by the market markers when they process the order at the bid/ask prices. Now you can understand what it means when a financial brokerage says that they get their revenues the trades that “cross the spread.”
By looking at a bid-ask spread you can understand the supply and demand of an asset. In this case, the bid in a way represents a demand while the ask represents the supply for a commodity/asset. So, if these two prices go apart from each other, this action shows a change in supply and demand.
The bid-ask spread can be significantly impacted by both the “bids” as well as the “asks.” You can expect this spread to increase or widen a lot in two scenarios. One where lesser participants place the limit orders to purchase a security (meaning lesser bid prices). Another where lesser sellers place limit orders for selling. All in all, it becomes necessary for you to take into account the bid-ask spread. You want to make sure that you place your buy limit order successfully.
People who have been in the trade for long who are quick to recognize risks in the market can also widen the spread. They can do so by increasing the gap between the best bid as well as the ask that they are offering at any given moment. You should be careful, for experienced traders can also attempt to profit by manipulating changes inside the bid-ask spreads.
Examples Of Bid-Ask Spread
To understand what a bid-ask spread entails, you can try to follow this example.
Suppose that the bid price for a commodity is $19 whereas the ask price for the same is $20. In this case, the bid-ask spread for the commodity will be $1. You can also write the bid-ask spread in terms of percentage. This can be calculated by taking the percentage of the lowest ask/sell price.
In the above example, the bid-ask spread in percentage would be $1 divided by the lowest ask price, i.e., $20, which will be $5. Here the bid-ask spread percentage is calculated as follows:
$1/$20 x 100 = 5%
You will find that this commodity will close if a buyer makes an offer to buy the commodity at more price. This can also happen if a seller decides to sell the commodity at a lower price.
You can also understand the bid-ask spread with another example that you can relate to.
Suppose the famous financial giant Morgan Stanley Capital International (MSCI) wishes to buy 1,000 shares of ABC stock for $10. On the other hand, another company wishes to sell 1,500 of its shares for $10.25. In this case, the bid-ask spread will be:
$10.25 (asking price) – $10 (bid price) = 0.25 or 25 cents.
When you look at this spread and decide to give 1,000 shares, you can do so by selling the shares at $10 to MSCI. On the flip side, you would also know that you can purchase 1,500 shares offered by the other company for $10.25.
You will find that the prices of the stocks and the size of the spreads can be determined by having a look at supply and demand. The more potential buyers, the more bid there are. While if there are many sellers, it would mean there will be more asks.
Important Elements Of A Bid-Ask Spread
There are several key factors to the bid-ask spread. You should be aware of them as you step into the world of trading. The following are some of the important elements of the bid-ask spread that you need to be familiar with.
- Liquid Market: A market that is highly liquid serves as an ideal exit when looking to make a profit out of any commodity.
- Supply and Demand: There should be a difference in supply and demand of a commodity, which can give rise to a spread.
Note: If you are looking to trade, you should make use of a limit order and not a market order. This means that you should be deciding your entry point to not miss a good opportunity of a spread.
- Trades: You can undertake bid-ask spread trades for all types of securities/commodities. The most used ones remain foreign exchange (Forex) and varied trading commodities.
Understanding Supply and Demand
If you want to put your feet into trading, you should also understand the concept of supply and demand. The concept of supply and demand is deeply integrated with the bid-ask spread.
A supply is known as the abundance or simply the volume in which a commodity is present in a marketplace. Whereas a demand means a person’s willingness to offer a particular rate or price for a commodity.
In such a scenario, a bid-ask spread showcases the points where buyers are willing to buy, and sellers are willing to sell. When a bid-ask spread is tight/less, it reflects an actively traded commodity along with agreeable liquidity. On the other hand, a bid-ask spread that is too wide/big can mean the contrary.
When there is a big imbalance of supply and demand along with low liquidity, the bid-ask spread tends to expand a lot. In such cases, the popular commodities/securities (say Google’s stocks or Apple’s stocks) will end up having a less spread. This means that a commodity that is not traded much can have a bigger spread.
Bid-Ask Spread’s Connection To Liquidity
If you are wondering how liquidity is related to a bid-ask spread, you now will be able to know the real connection.
A bid-ask spread can carry in size from one commodity to the other due to the difference in liquidity of each commodity. In other words, a bid-ask spread is a good measure of a market’s liquidity. You will find that some markets happen to be more liquid as compared to others. This is also reflected by their spreads, which tend to be lower.
Mainly, the price takers (who initiate transactions) demand/require liquidity, whereas the market makers tend to supply/provide liquidity. You can understand it better with an example:
Currencies are known to be the biggest liquid asset throughout the globe. This means that its bid-ask spread in the market will be very small/tight. It is so less that their spread can be calculated in fractions of a penny. On the contrary, assets that are not liquid, like the small-cap stock, tend to have a good spread.
You should note that the bid-ask spread is great at reflecting the risks associated with trade offerings. For instance, suppose the options may tend to have bid-ask spreads that show a way the larger percentage of its price than say an equity trade. In such a case, you should note that the size of the spread can be based on liquidity, but also on the way the prices can change.
Summing Up
The bid-ask spread is an interesting concept that you should know about when entering trading. A bid-ask spread is mainly the difference between the ask price and the bid price. The more the size of the bid-ask spread, the lesser traded the commodity is. While commodities which are actively traded will always have a tight bid-ask spread.
Bid-ask spreads are dependent on various factors, and hence it becomes vital to have a knowledge of all to make a successful trade.