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

What Is a Bid-Ask Spread?

A bid-ask spread is the amount by which the ask price exceeds the bid price for an asset in the market. 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. An individual looking to sell will receive the bid price while one looking to buy will pay the ask price.

Understanding Bid-Ask Spreads

A security's 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 the price 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 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.

Bid-ask spread trades can be done in most kinds of securities, as well as foreign exchange and commodities. Traders use the bid-ask spread as an indicator of market liquidity. High friction between the supply and demand for that security will create a wider spread. Most traders prefer to use limit orders instead of market orders; this allows them to choose their own entry points rather than accepting the current market price. There is a cost involved with the bid-ask spread, as two trades are being conducted simultaneously.

Bid-Ask Spread Calculation

The bid-ask spread is calculated as the difference between the highest price that a buyer is willing to pay for a security and the lowest price that a seller is willing to accept. Mathematically, the bid-ask spread can be represented as:

While the basic calculation of the bid-ask spread involves pretty simple math, more complex calculations may be necessary. During dynamic, volatile markets, there may be more specific things that happen where it’s not so straightforward. For example, in markets with multiple tiers of bids and asks, you might calculate a weighted average spread that takes into account the distribution of orders at different price levels.

You could also lean on the effective spread. The effective spread accounts for the impact of market orders. This calculation is the difference between the execution price of a market order and the midpoint of the bid-ask spread. This can be a more accurate reflection of the true cost of trading, especially in highly liquid markets.

You can also convert a bid-ask spread to a percentage spread if you’re less interested in the actual dollar amount but you want more of a comparative metric. For instance, if the bid-ask spread is $1 and a stock is trading at $50, you may care more about a percentage spread of 2% ($1 / $50) as opposed to the nominal amount of $1. 

Bid-Ask Spread and 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 also on how quickly the prices could change.

Bid-Ask Spread Example

If the bid price for a stock is $19 and the ask price for the same stock is $20, then the bid-ask spread for the stock in question is $1. The bid-ask spread can also be stated in percentage terms; it is customarily calculated as a percentage of the lowest sell price or ask price.

For the stock in the example above, the bid-ask spread in percentage terms would be calculated as $1 divided by $20 (the bid-ask spread divided by the lowest ask price) to yield a bid-ask spread of 5% ($1 / $20 x 100). This spread would close if a potential buyer offered to purchase the stock at a higher price or if a potential seller offered to sell the stock at a lower price.

Factors That Impact the Bid-Ask Spread

There’s a bunch of things that drive bid-ask spreads. The list below may not contain everything, but it’s a good overview of why bid-ask spreads exist and how they may change. 

• Market Liquidity: Liquidity is the ease with which an asset can be bought or sold in the market without significantly impacting its price. Very generally speaking, highly liquid assets have narrower bid-ask spreads because there are more buyers and sellers willing to trade at or near the current market price.
• Volatility: Higher volatility often leads to wider bid-ask spreads because it increases the uncertainty in the market. This can lead to widening spreads to mitigate potential losses from price fluctuations.
• Trading Volume: This goes hand in hand with liquidity. Higher trading volume typically results in narrower spreads as increased trading activity enhances market efficiency and reduces the impact of transaction costs. Part of the higher trading volume may be attributed to liquidity, though it could also signal a relatively illiquid stock simply being transacted a lot in a shorter period. 
• Asset Class: Different asset classes can have different levels of liquidity and volatility which then in turn impacts their spreads. For example, stocks of large, well-established companies often have narrower spreads compared to smaller, less-traded stocks. As you might expect, those larger stocks have greater liquidity and often have higher trading volumes. 
• Time of Day: Bid-ask spreads may vary throughout the trading day. Spreads may widen during slower times of the day or widen during busy times. This also ties into alignment with external events; consider how trading volume may change depending on the timing of a Federal Reserve meeting. 

Bid-Ask Spreads and Market Makers

We'll wrap up this article by touching on market makers. Market makers do play a part in how bid-ask spreads are formulated. They are able to make this impact because they:

• Provide Liquidity: Market makers continuously quote both bid and ask prices for securities, ensuring there are readily available prices at which traders can buy or sell. Market makers facilitate smooth and efficient trading, therefore reducing the bid-ask spread.
• Narrow Spreads: Market makers compete with each other to capture order flow by offering the best bid and ask prices. This competition often leads to tighter spreads as market makers strive to attract trades.
• Manage Risk: Market makers assume the risk of holding inventory in securities. They profit from the bid-ask spread, buying securities at the bid price and selling them at the ask price. To manage their risk exposure, market makers adjust their bid and ask prices based on factors such as market conditions, volatility, and inventory levels.
• Adapt to Market Conditions: Market makers continuously monitor market conditions and adjust their quotes accordingly. During periods of high volatility or low liquidity, market makers may widen spreads to compensate for increased risk.
• Enhance Market Efficiency: Market makers enhance market efficiency by reducing price discrepancies between buyers and sellers. By providing competitive bid and ask prices, market makers help ensure that securities trade close to their fair market value.
• Support Order Flow: Market makers support order flow by executing trades on both the buy and sell sides of the market. This helps maintain orderly trading and prevents large imbalances between buyers and sellers, which can lead to increased market volatility.
  

The Bottom Line

The bid-ask spread serves as an effective measure of liqudity, as more liquid securities will have small spreads while illiquid ones will have larger ones. Investors should keep an eye on the spread of any security they wish to buy or sell to get a sense for how frequently it trades and to decide on the type of order to use when making a transaction.

Correction—Dec. 4, 2022: This article’s question-and-answer segment was edited from a previous version that incorrectly defined bid-ask spread.