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Published on: Mar 1, 2024
#Financial Markets
#Trading 101
The bid-ask spread is the difference between the bid price (last price) and the ask price (quoted price).
➔ A bid-ask spread is the difference between the bid price and the ask price of an asset.
➔ A bid price is almost always lower than an ask price.
➔ While ask symbolises supply for an asset, bid symbolises demand for it.
➔ The more liquid a market is, the lower the bid-ask spread.
A trader often navigates uncharted territories in the markets and needs to know the ins and outs of the system. One such practice is bid-ask spread that is quite common in the stock markets but isn’t understood by many.
Those who look up stock quotes all the time must have most likely noticed bid and ask prices. But among so many complex concepts to take note of, it is not easy for traders to understand this peculiar concept. Fret not as today, we will cover bid-ask spread, bid price and ask price in detail. Let’s dive right in.
A bid-ask spread is the difference between bid price and ask price for an asset:
• Ask Price is the lowest price that a seller is willing to accept for an asset.
• Bid Price is the highest price that a buyer is willing to pay for an asset.
Let's take an example of a bid-ask spread. Suppose that a seller offers an asset for $50 (ask price) which a buyer purchases for $42 (sell price). Now, how will you calculate the bid-ask spread? Here, the bid-ask spread is ($50-$42=) $8.
You might wonder why we have taken a situation where the bid price is lower than the ask price. But more often than not, this is indeed the case: a bid price is almost always lower than an ask price. It’s so because this is how a market functions. Let’s take a real-life scenario.
When you go to a shop to buy a pair of shoes, the shopkeeper quotes you a price (ask price). But you don’t instantly buy it for the same price (unless you’re Paris Hilton).You haggle, you bargain, you negotiate until both of you agree on a price that you think is fair for the shoes (bid price).
The difference is the spread. While ask symbolises supply for an asset, bid symbolises demand for it.
The difference between the bid price (last price) and the ask price (quoted price) is the bid-ask spread.
This is a simple formulate to calculate the spread. But a few more factors need to be considered to calculate the spread in a dynamic market.
Suppose you want to calculate the bid-ask spread over a period of time during a trading day. There are multiple pairs of bids and asks during a trading day. In this case, you will calculate the average of the spreads at different price levels during the period. You can also calculate the bid-ask spread in terms of percentage. The formula to calculate a percentage spread is dividing ask price by the spread.
• Bid-ask Spread (in percentage) = Bid-ask Spread/Ask Price
• Suppose a stock is trading at $120 and its bid-ask spread is $4, then,
• Bid-ask Spread (in percentage) = 4/120 = 0.03%
Please ensure that you consider transaction fees while calculating the bid-ask spread as these fees are an inevitable part of any transactions. You should also consider charges on currency exchanges which will be deducted from your profits.
In a market, there are two major players: the price taker and the market maker.
• A market maker, usually employed by brokerage firms, chooses to sell securities at the ask price and to buy securities at the bid price.
• A price taker or trader, in front of the market maker, chooses to buy the securities at the bid price or sell the securities at the ask price.
The bid-ask spread is the difference between bid price and ask price. In essence, the spread is the principal transaction cost of trading. As the market maker collects bid-ask spreads in the market, they report the spreads as revenues that are derived from traders "crossing the spread." Price takers or traders who simply buy and sell regular stocks don’t pay much attention to the bid-ask spread, given that it accounts for such a small fraction of most investments.
However, bid-ask spreads bring home a significant amount of profit for market makers. Market makers profit from the bid-ask spread as they keep buying assets at the bid price and keep selling at the slightly higher ask price.
Market makers are financial institutions that are looking to purchase or sell assets at a specified price. The bid-ask spread is where the market makers realise their profits, and this is what drives the smooth functioning of a stock market. Thus, the market makers ensure that the market has sufficient liquidity for different assets in exchange for the profits realised through spreads.
The price of a security is determined by the market's assessment of the given asset at a point in time. The ask demands liquidity and the bid supplies liquidity. The bid-ask spread increases if fewer traders place limit orders to buy an asset or if fewer sellers place limit orders to sell an asset. Conversely, the spread falls in the reverse scenario. The more liquid a market is, the lower is the bid-ask spread.
An asset with a narrow bid-ask spread is demanded the most. In a highly liquid market, it often happens that the bid price is the same as the ask price, making the spread zero. It’s so because a competitive market matches willing buyers and sellers quite efficiently. For example, markets for forex, futures, bonds, and stocks are highly liquid.
In fact, the bid-ask spread in the currency market can be counted in pennies. On the other hand, markets for debt instruments and over the counter (OTC) stocks are very illiquid. It means that the bid-ask spread of an asset is different from that of another asset due to the difference in the liquidity of each asset.
In general, a bid-ask spread of an asset is inversely proportional to its liquidity. Now, who are the dealers of liquidity in the market? We will again go back to the primary participants in the market. A price taker or trader demands liquidity, and a market maker supplies liquidity.
If you are a market maker, you can use bid-ask spreads to gain profits in the market. The spread isn’t very profitable to an ordinary investor as the resultant profit is very small. But when applied to millions of transactions, the spreads add up to significant profits for the market makers. If you have access to a sufficient amount of liquidity, you can make enough profits during a good trading day.
Then, you can even do with a few trades with low spreads as you will execute such a large number of trades that even those with low spreads, when multiplied, offer high profits. In case you have only limited liquidity, we recommend you go for trades with low liquidity. Since low liquidity trades offer higher bid-ask spreads, they offer the best opportunity to gain profits as a market maker.
A bid-ask spread is the primary financial instrument that garners profits for market makers. So, market makers or liquidity providers should closely observe evolving trends in the markets to realise gains through bid-ask spreads. A market maker must try to gauge their interests in the face of the requirements of the traders on any given trading day.
A wider spread certainly seems lucrative but be aware that an asset segment with wider spreads spurs a tougher competition among the market makers. On the other hand, a narrow spread might seem insignificant but can help a market maker realise strong gains when multiplied in millions or even thousands. It must be obvious to you now that a market maker shouldn’t put all their eggs in one basket; they should engage with assets with both wider and narrower spreads.
The proportion of these two kinds of assets should be decided on a periodic basis, given the evolving conditions in the market. Since market makers compete to provide liquidity in the market, the competition leads to narrower bid-ask spreads. Market makers are the holders of tradable securities in the market and provide liquidity in the market. They buy securities at bid prices and sell them at ask prices. These players keep adjusting ask and bid prices as per the changing market conditions, thereby managing the market in the process.
As market makers create the right conditions for securities to be traded at fair prices, they streamline the trading process and increase the efficiency of the market. Now, how should a trader or price taker consider a spread while trading in the stock market?
A trader should use the benchmark of a bid-ask spread to strategise different kinds of trading orders in the market:
• Market Order: A market order is a trade order that lets you sell or buy securities immediately. A bid-ask spread allows you to assess if a market order is executed at the approximate bid-ask price.
• Limit Order: A limit order allows for the purchase and sale of shares at a specific price or higher. So, if you make an order to buy an asset at a price more than $100 per share, your order will only be executed if the stock's value falls below $100.
• Stop Order: A stop order allows you to trade (buy or sell) a stock once it hits a certain price point. As a result, you may execute and profit from a trade as soon as the stop order reaches it.
This way, traders can use different kinds of trading orders to execute trades at appropriate prices. If the market is volatile, it can prove to be risky to place a market order. In such a situation, a trader should opt for a limit order so that you purchase a stock only at a price that is affordable. A trader or price taker is the other crucial participant in a market as it is he who demands liquidity from the market.
A bid-ask spread is an important factor in the market. It is recommended for traders to keep in mind bid-ask spreads while executing trades. When purchasing or selling an asset, the bid-ask spread should be carefully considered, especially if it is a low-liquidity transaction.
Some assets, such as large-cap stocks, may have such high supply and demand that the spread is very small. Other assets, such as micro-cap stocks and certain bonds, may have spreads that account for a significant portion of the asset's price. Please note that when we say an asset, it is not limited to security but also encompasses foreign exchange and commodities.
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A bid-ask spread is the difference between bid price and ask price of an asset.
The formula for calculating bid-ask spread is: Bid-ask spread= Ask price - Spread price
The bid-ask spread indicates the act of negotiation in the market. For a market maker, it indicates the principal transaction cost of trading.
A bid price is almost always lower than an ask price because this is how a market functions.
The ask demands liquidity and the bid supplies liquidity. The more liquid a market is, the lower is the bid-ask spread. An asset with a narrow bid-ask spread is demanded the most.
This article is for informational purposes only and not intended as investment or financial advice. It contains opinions and speculations that are subject to change without notice.
The author and publisher disclaim any liability for decisions made based on the content of this article. Readers are advised to conduct their own research and consult a financial advisor before making investment decisions.
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