Bid-Ask Spread

What it is

The bid-ask spread is the difference between the highest price a buyer is willing to pay (the bid) and the lowest price a seller is willing to accept (the ask) for a security. It represents the primary transaction cost of trading and is collected by market makers or liquidity providers who buy at the bid and sell at the ask.

Key takeaways

• The spread is effectively the cost of crossing the market: buyers pay the ask, sellers receive the bid.
• A narrow spread indicates high liquidity; a wide spread indicates low liquidity or higher perceived risk.
• Traders can reduce cost exposure by using limit orders instead of market orders when spreads are wide or volatile.

How it’s calculated

Basic formula:
Bid-Ask Spread = Ask Price − Bid Price

You can also express the spread as a percentage:
Percentage spread = (Ask − Bid) / Ask (or sometimes divided by the midpoint)

Example:
* Bid = $19, Ask = $20 → Spread = $1 → Percentage = $1 / $20 = 5%

Another practical example:
* Buying 100 shares where spread = $0.05 → Total spread cost = 100 × $0.05 = $5

More precise measures

• Effective spread: compares the execution price of a trade with the midpoint of the quoted bid and ask to capture the true cost of a market order. This is often used in analyses of trade execution quality and high-frequency environments.
• Weighted or depth-adjusted spreads: in markets with multiple price levels, a weighted average that accounts for order sizes at different quotes may give a fuller picture of trading cost.

Liquidity and what the spread signals

The bid-ask spread is a practical measure of market liquidity:
* Narrow spreads → many buyers and sellers, higher trading volume, lower execution cost.
* Wide spreads → fewer participants, lower volume, higher cost and risk of price movement.

Spreads also reflect perceived risk: assets with uncertain or fast-changing prices (e.g., certain options, small-cap stocks, or thin OTC instruments) typically have wider spreads.

Factors that influence spread width

• Liquidity / trading volume: higher volume generally narrows spreads.
• Volatility: greater uncertainty widens spreads as liquidity providers protect against rapid price moves.
• Asset class: forex and large-cap equities often have tighter spreads than small-cap stocks or less liquid derivatives.
• Market structure and competition: more competitive, transparent venues produce tighter spreads.
• Time of day: spreads can widen during slow trading hours or around important news events.

Role of market makers

Market makers (or liquidity providers) continuously quote bid and ask prices to facilitate trading. Their functions include:
* Providing liquidity and supporting order flow.
Competing to offer tighter quotes, which narrows spreads.
Managing inventory and risk by adjusting quotes during volatile periods.
* Capturing the spread as compensation for the risk and cost of maintaining liquidity.

Arbitrage and the spread

Arbitrageurs and algorithmic market makers look for opportunities where prices (or spreads) differ across venues. Simple examples:
* Buying an asset where the ask is lower on one exchange and selling where the bid is higher on another.
* Posting both bid and ask quotes to capture small profits repeatedly (market-making strategies).

Because such opportunities close quickly, these strategies rely on speed, low transaction costs, and risk management.

Practical trading tips

• Check the spread before placing market orders—wide or shifting spreads increase the risk of poor fills.
• Use limit orders to control execution price when spreads are wide or liquidity is thin.
• For large orders, consider slicing the order or using execution algorithms to avoid crossing wide spreads and moving the market.

Conclusion

The bid-ask spread is a fundamental concept that measures the cost and liquidity of trading a security. Monitoring spreads—along with volume and volatility—helps traders choose appropriate order types and manage execution costs.