What Is a Bid-Ask Spread?
The bid-ask spread is the difference between the highest price a buyer is ready to pay (the bid) and the lowest price a seller is willing to accept (the ask) for an asset in the market. Essentially, when you sell an asset, you receive the bid price, and when you purchase, you pay the ask price. This spread is a fundamental aspect of market transactions, reflecting the supply and demand dynamics for that particular asset.
How Bid-Ask Spreads Work
The value of an asset at any given moment reflects the market’s perception of its worth. The bid price represents what buyers are willing to pay, while the ask price is the minimum that sellers are agreeable to. Market makers, typically associated with brokerage firms, are responsible for setting these prices. Their earnings derive from the spread, which is the primary trading cost aside from any commissions. This spread is an indicator of the asset’s desirability – the bid demonstrates demand, and the ask indicates supply.
The bid-ask spread fluctuates in response to the volume of buying and selling activity. A sparse number of bids (buyers) or asks (sellers) results in a broader spread. Market makers may also expand the spread in anticipation of significant market movements.
Bid-Ask Spread and Liquidity
The bid-ask spread’s magnitude is influenced by the asset’s liquidity, indicating how readily it can be traded without impacting its price. Assets with higher liquidity, such as major currencies, feature narrower spreads, whereas less liquid assets, like stocks of smaller companies, exhibit wider spreads.
Additionally, the spread reflects the perceived risk level of an asset by market makers. Higher risk instruments, such as options or futures, often have larger spreads compared to stocks or currencies.
Bid-Ask Spread Example
When an asset has a bid of $19 and an ask of $20, the spread equals $1. To express this spread as a percentage, divide it by the ask price. Thus, dividing $1 by $20 results in a spread of 5%. The spread diminishes if a buyer increases their bid or a seller reduces their ask.
Using the Bid-Ask Spread
Many traders prefer to specify their desired buying or selling price, opting for a limit order rather than a market order, which accepts the prevailing price. The spread represents an expense as it essentially involves executing two simultaneous trades.
The Takeaway
The bid-ask spread serves as an immediate indicator of an asset’s trading frequency – a narrow spread suggests frequent trading, while a wider one indicates less activity. Monitoring the spread can guide your trading strategy, aiding in deciding whether to set a specific price or accept the market’s current rate.