What is Bid-ask Spread? Definition of Bid-ask Spread, Bid-ask Spread Meaning

4. Other Applications

Well-performing estimators of transaction costs can be applied in a variety of research areas. To illustrate their potential uses, we propose two simple applications. The first example is a description of the historical spread estimates for stocks listed on NYSE (AMEX) from 1926 (1962) to 2015. In the second example, the spread estimates are applied to measure systematic risks originating from liquidity issues.

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Bid-Ask Spread Example Calculation

Suppose a company’s shares are publicly listed on an exchange and trading at $24.95 per share.

The highest bid price is stated as $24.90, and the lowest ask price is set at $25.00, which is why the current share price reflects the “mid-point” between the highest bid and lowest ask price.

Given those two figures, the bid-ask spread equals the difference, $0.10.

  • Bid-Ask Spread = $25.00 – $24.90 = $0.10

We can now express the spread as a percentage by dividing the spread of ten cents by the ask price, which comes out to 0.40%.

  • Bid-Ask Spread (%) = $0.10 ÷ $25.00 = 0.40%

2. Cost of assembling and trading

The cost of assembling and trading the basket of securities inside an ETF may impact the spread. For instance, if the ETF invests in foreign securities, there will be additional costs to convert Canadian dollars to the underlying currencies. An ETF that buys European dividend stocks first needs to buy Pounds Sterling, Euros, Swiss Francs, and so on.

Another example would be regulatory costs and taxes. In the United Kingdom for example, there is a 0.5% fee every time an investor buys a stock on a stock exchange, called a Stamp Duty. This cost would be reflected in the spread on any ETF associated with U.K. securities.

4. Market risks

Bid-ask spreads can widen during times of heightened market risk or increased market volatility. If market makers are required to take extra steps to facilitate their trades during periods of volatility, spreads of the underlying securities may be wider, which will mean wider spreads on the ETF.

Understanding Bid-Ask Spreads

A securities price is the market's perception of its value at any given point in time and is unique. To understand why there is a "bid" and an "ask," one must factor in the two major players in any market transaction, namely theprice taker(trader) and the market maker (counterparty).

Market makers, many of which may be employed by brokerages, offer to sell securities at a given price (the ask price) and will also bid to purchase securities at a given price (the bid price). When an investor initiates a trade they will accept one of these two prices depending on whether they wish to buy the security (ask price) or sell the security (bid price).

The difference between these two, the spread, is the principal transaction cost of trading (outside commissions), and it is collected by the market maker through the natural flow of processing orders at the bid and ask prices. This is what financial brokerages mean when they state that their revenues are derived from traders "crossing the spread."

The bid-ask spread can be considered a measure of the supply and demand for a particular asset. The bid can be said to represent the demand for an asset and the ask represents the supply, so when these two prices move 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.

Large Spreads

When the bid and ask prices are far apart, the spread is said to be large. If the bid and ask prices on the EUR, the Euro-to-U.S. Dollar futures market, were at 1.3405 and 1.3410, the spread would be five ticks.

A large spread exists when a market is not being actively traded, and it has low volume, so the number of contracts being traded is fewer than usual. Many day trading markets that usually have small spreads will have large spreads during lunch hours or when traders are waiting for an economic news release.

Trading the Spread

Some day traders try to make trades that take advantage of the spread, and they prefer a large spread. Trading systems that trade the spread are collectively known as “scalping” trading systems. The traders are known as “scalpers,” because they only want a few ticks of profit with each trade. One example of trading the spread would be to place simultaneous limit orders—rather than market orders—to buy at the bid price and sell at the asking price, then wait for both orders to be filled.

Dont Fall for Free Trading

If you see a company advertising free trades or promising to help you grow wealth for free, think twice before you pull the trigger.

It’s mostly a marketing ploy.

You will be paying the bid-ask spread (sometimes twice), even if a trade appears to be free.

“Free” trading may tempt you to change your investments more frequently than necessary, which can increase internal costs and reduce long-term returns.

Our advice – stick to low-cost index investment and be a boring investor instead.

What Causes a Bid-Ask Spread to Be High?

Bid-ask spread, also known as "spread", can be high due to a number of factors. First, liquidity plays a primary role. When there is a significant amount of liquidity in a given market for a security, the spread will be tighter. Stocks that are traded heavily, such as Google, Apple, and Microsoft will have a smaller bid-ask spread.

Conversely, a bid-ask spread may be high to unknown, or unpopular securities on a given day. These could include small-cap stocks, which may have lower trading volumes, and a lower level of demand among investors.

Bid-Ask Spread Example

For example, let’s say an investor wants to buy 1,000 shares of Company A for $100 and has placed a limit order to do so. Let’s assume another investor has placed a limit order to sell 1,500 shares at $101. If these 2 orders represent the highest bid and the lowest ask price in the market, the spread on this stock is $1.

Bid-Ask Spread Definition

The bid is indicative of the demand within the market, whereas the ask portrays the amount of supply.

The bid-ask spread equals the lowest asking price set by a seller minus the highest bid price offered by an interested buyer.

Electronic exchanges such as the NYSE or Nasdaq are responsible for matching bid and sale orders in real-time, i.e. facilitating transactions between the two parties, buyers and sellers.

  • Bids: Interest in Buying
  • Ask: Interest in Selling

Each purchase and sell order comes with a stated price and the number of applicable securities.

The orders are automatically arranged in the order book, with the highest bid ranked at the top to meet the lowest sale offer.

  • Bid Prices: Ranked from Highest to Lowest
  • Ask Prices: Ranked from Lowest to Highest

If a transaction is completed, one side must’ve accepted the opposite side’s offer — so either the buyer accepted the asking price or the seller accepted the bid price.

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