Understanding Bid-Ask Spread
Understanding Bid-Ask Spread
Understanding Bid-Ask Spread
By AKHILESH GANTI
The bid-ask spread can be considered a measure of the supply and demand for
a particular asset. Because the bid can be said to represent demand and the ask
to represent the supply for an asset, it would be true that when these two prices
expand further apart the price action reflects a change in supply and demand.
The depth of the "bids" and the "asks" can have a significant impact on the bid-
ask spread. The spread may widen significantly if fewer participants place limit
orders to buy a security (thus generating fewer bid prices) or if fewer sellers
place limit orders to sell. As such, it's critical to keep the bid-ask spread in mind
when placing a buy limit order to ensure it executes successfully.
Market makers and professional traders who recognize imminent risk in the
markets may also widen the difference between the best bid and the best ask
they are willing to offer at a given moment. If all market makers do this on a given
security, then the quoted bid-ask spread will reflect a larger than usual size.
Some high-frequency traders and market makers attempt to make money by
exploiting changes in the bid-ask spread.
KEY TAKEAWAYS
The bid-ask spread is essentially the difference between the highest price
that a buyer is willing to pay for an asset and the lowest price that a seller
is willing to accept.
The spread is the transaction cost. Price takers buy at the ask price and
sell at the bid price but the market maker buys at the bid price and sells at
the ask price.
The bid represents demand and the ask represents supply for an asset.
The bid-ask spread is the de facto measure of market liquidity.
The Bid-Ask Spread's Relation to Liquidity
The size of the bid-ask spread from one asset to another differs mainly because
of the difference in liquidity of each asset. The bid-ask spread is the de
facto measure of market liquidity. Certain markets are more liquid than others
and that should be reflected in their lower spreads. Essentially, transaction
initiators (price takers) demand liquidity while counterparties (market makers)
supply liquidity.
For example, currency is considered the most liquid asset in the world and the
bid-ask spread in the currency market is one of the smallest (one-hundredth of a
percent); in other words, the spread can be measured in fractions of pennies. On
the other hand, less liquid assets, such as small-cap stocks, may have spreads
that are equivalent to 1 to 2% of the asset's lowest ask price.
Bid-ask spreads can also reflect the market maker's perceived risk in offering a
trade. For example, options or futures contracts may have bid-ask spreads that
represent a much larger percentage of their price than a forex or equities trade.
The width of the spread might be based not only on liquidity, but on how much
the price could rapidly change.