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What Is a Bid-Ask Spread and How Does It Work?

May 6, 2022
8
min

The bid-ask spread is the investor’s cost of doing business with the broker. For the broker, the spread is what they earn for providing the service to the investor.

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The bid-ask spread in finance is the difference between the price an investor is willing to pay for something, and the price the seller wants for the thing.

A transaction takes place when the seller agrees to accept the bid, or offer, and the buyer is willing to pay the asking price. This occurs in a marketplace, such as a stock exchange, where buyers and sellers come together to hash out prices each finds acceptable.

What is a bid-ask spread?

The bid-ask spread is the price difference between what buyers are willing to pay (the bid) and what sellers will accept (the ask) for something. It is a key dynamic behind every trade of a stock as well as exchange-traded funds (ETF); it also is found in some other financial markets.

Investors encounter the bid-ask spread when they want to buy or sell securities. A type of broker known as a “market maker”—who is ready to buy or sell, often without any delay—sets the bid and the ask prices and “makes” the market—they stand willing to buy when others want to sell and vice versa.

The bid-ask spread is essentially the investor’s cost of doing business with the broker, or the price of executing a trade. For the broker, the spread is what they earn for providing the service to the investor.

How does a bid-ask spread work? 

Here is a hypothetical example of how a bid-ask spread works:

Imagine a company called Widget Corp. whose shares last traded at $99.50. A broker quotes the shares for online trading at $99 bid and $100 ask. This means if an investor owns Widget and wants to sell, the best price brokers will pay is $99. Or if an investor wants to buy Widget, the lowest price brokers will sell for is $100. The price spread between these two is $1.

The larger the spread, the more costly it is for the investor to trade. A broker would like to earn a generous $1 spread, but may find fewer investors willing to trade. On the other hand, a smaller spread, say 10 cents a share, might get the broker thousands of trades.

Bid-ask spread pricing

Bid-ask spreads can vary during the day. They are often wide before trading begins, and they narrow as the day progresses. For example, spreads on big-name stocks in the Dow Jones Industrial Average or Standard & Poor’s 500 Index may open at several dollars a share, and then shrink to a few cents by midday. Similarly, the biggest, most widely traded ETFs based on these indexes trade at very small spreads of a few cents.

Most large-cap stocks trade at much tighter bid-ask spreads, as brokers make up in volume of trades for the slim per-share spread profit.

Bid and ask sizes

Bid and ask sizes indicate how many shares market makers are ready to trade at the respective bid and ask prices. The size number is usually in round lots of 100 shares, or 10 shares for the highest-priced stocks, such as Amazon and Google parent Alphabet.

For instance, if a market monitor for ABC Corp. looks like this:

Bid: 125.50 X 500                              Ask: 126.25 X 400

This means 500 X 100 or 50,000 shares can be sold to market makers at $125.50 by investors willing to sell. And 400 X 100 or 40,000 shares can be bought from market makers by investors willing to pay $126.25. Bid and ask sizes can change during the trading day, just as spreads change.

A bid size that’s larger than the ask size indicates there’s more demand to buy than supply of shares to sell, suggesting the stock price may rise, and vice versa when ask sizes are larger.

Bid-ask spreads and liquidity

Bid-ask spreads are driven by two things: liquidity and volatility. Spreads generally have an inverse relation to market liquidity—not just for stocks but in other financial markets such as currencies. The smaller the spread, the more frequently the stock, other asset, is traded.

Highly liquid stocks—those most easily traded at a given moment—typically have the narrowest spreads. Thinly traded stocks often have wider spreads, as market makers want to be compensated for the greater difficulty in buying and selling. Stocks with greater price volatility also have wider spreads, because market makers are at greater risk of trading them at a loss.

Calculating the bid-ask spread percentage

The costs of bid-ask spreads can add up. So for investors who trade frequently, it may be important to calculate a bid-ask spread percentage. Subtracting bid-ask percentage costs from percentage investment returns gives a more accurate picture of an investor’s profits. It also allows investors to make comparisons among stocks regardless of nominal stock prices and nominal spreads.

To calculate a bid-ask spread percentage, take the bid-ask spread and divide it into the ask price.

For an example, let’s go back to the imaginary Widget Corp. The bid-ask spread is $1, or 1% of the $100 ask price. If an investor bought and held Widget shares for a year before selling at $108, for a return of 8%, subtracting the cost of bid-ask spread reduces the return to 7%. Even with smaller spreads, the effect on returns over time can accumulate in portfolios that hold many stocks.

As for comparing the spreads on high-priced and low-priced stocks, percentages show the true difference. Let’s say a company called ABC Inc. trades at $3,000, and investors see a bid-ask spread of $1. At the same time, XYZ Ltd. trades at $300, and the current bid-ask is 20 cents. Even though the $1 nominal spread is larger, on a percentage basis it’s smaller. Here’s how to compare them:

The bid-ask spread percentage of ABC: 1/3,000 = 0.00033 or 0.033%

The bid-ask spread percentage of XYZ: 0.2/300 = 0.00067 or 0.067%

Types of stock orders and bid-ask spread

Investors can use different types of stock orders, when considering the effect of bid-ask spreads on their trading:

Market order

A market order is the most common order type, and is used to buy or sell shares at the going market price. It reflects the bid-ask spread at the time. So per the Widget Corp. example above, if the bid price is $99 and the ask price $100, an investor placing a buy market order for Widget shares would pay $100. If the investor owns Widget and places a sell market order, they will get $99.

The tradeoff for investors is speed: the trade is quick because the investor imposes no conditions on executing the transaction. In such cases where the spread is small, completion of the trade is more important for long-term investors than gaining a few cents a share. 

Limit order

In a limit order, the investor restricts the price on the order, such as a cap on the purchase price or a floor on the selling price. Someone wanting to buy Widget, for example, might instruct a broker not to pay more than $98 a share; or if selling, the investor might tell the broker not to accept less than $101.

Limit orders allow investors to control trading prices and the cost of bid-ask spreads, but execution may be delayed while the investor waits for the market price to rise or fall to the specified level. A buy limit order for Widget, for example, would require the investor to wait until a broker’s ask price drops to $98 or lower; for a sell limit order, the investor must wait for the bid price to rise to $101 or higher. 

Stop order

A stop order instructs the broker to begin a trade once the stock rises or falls to a certain price, called the stop or trigger price. A buy stop order, for example, would be triggered when the stock rises to a specified price; conversely, a sell stop order would be triggered when the stock declines to a certain price.

Stop orders can be risky in volatile markets, because once triggered, they become market orders. If prices are changing rapidly, the investor might end up paying much more than the stop price by the time the order is executed, while a selling investor may get a price well below the stop price.

Some investors use a combined stop-limit order: The stop order gives the green light for the stock trade when the price reaches the stop, while the limit puts a brake on the stop order if the price becomes too low or too high. For instance, a sell stop-limit order for Widget might instruct the broker to sell if the price drops to $95 (the stop), but if the price keeps falling, to not sell lower than $90 (the limit).

The bottom line

Bid-ask spreads reflect the prices that buyers and sellers are willing to accept in the purchase or sale of a security such as a stock or ETF. This difference can be thought of as the price of executing a trade in financial markets. The spread also represents the compensation that professional market makers receive for standing ready to buy when investors want to sell and buy when they want to sell.

The bid-ask spread can cut into the returns of active traders, who may use stop and limit orders to better control their buying and selling prices. Spreads may be less important to long-term investors, who trade infrequently. Long-term investors may also prefer large-cap stocks and ETFs with small bid-ask spreads, which have a minimal impact on their returns.

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