Updated Mar 30, 2022

What is Bid & Ask spread?

What is Bid-ask spread?

Typically, the Bid-Ask spread is the difference between the bid (purchase/buy) price and the ask (offer/sell) price of a security. The value point at which the seller is ready to sell is the ask price while the point at which a buyer is ready to buy is the bid price.

A trade will take place only when in a marketplace, the two value points are matching. Herein, the seller and buyer agree to the prices that the corresponding party is offering.

Demand and supply are the two of the most important market forces that determine these prices. Similarly, the gap that exists between these two forces will determine the spread between buy-sell prices.

When this gap is large, the Bid-Ask spread is also large and vice-versa.

There are two major ways of expressing the Bid-Ask spread. One is absolute and the other is in percentage terms.

In case the market is highly liquid, spread values tend to be small. But if the market is less liquid or illiquid, spread values are reasonably larger.

Calculation of Bid-Ask Spread

The following equations are used to calculate the Bid-Ask Spread

• Bid-Ask Spread (absolute) = Ask/Offer Price – Bid/Buy
• Price Bid-Ask Spread (%) = ((Ask/Offer Price- Bid/Buy Price) – Ask/Offer Price)*100

In the market, there are going to be different buyers and sellers. They will also be willing to buy and sell securities at different price points. Correspondingly, each of the price points may not be used for calculating the Bid-Ask spread.

Instead, it is the lowest ask price, which is also the best sell price, and the highest bid price, which is also the best buy price that is used to calculate the Bid-Ask spread.

With the Bid-Ask spread being one of the most important trading points across the derivatives market, it is used by traders as an arbitrage tool. This way, they can make some money as they keep a check on the ins and outs of Bid-Ask Spread.

In the following arbitrage trades, Bid-Ask spread find widespread applications:

1. Inter-market spread

When a trader buys the futures of a security with a certain expiry date on any one exchange, and then, on another exchange, he sells the same security contract with a near-expiry.

1. Intra-market spread

Herein, one security's contract is bought and the other security's contract is sold, on the same exchange, such as silver and gold spread trade.

1. Calendar spread

In the case of Calendar spread, on the same exchange, a security contract of one expiry date is bought and another contract with a different expiry date is sold. The second contract is also of the same security.

Let us take a look at a few of the important elements associated with Bid-Ask Spread:

1. Irrespective of the security in question, the market for it should be highly liquid. Else, there may be a shortage of an ideal exit point for booking profit in a spread trade.
2. A certain degree of friction should exist in the demand-supply of the certain security. This facilitates the odds of a wider spread.
3. A trader shouldn’t be using ‘market order’ for facilitating spread trade. Else, it may be possible that a spread opportunity is missed. Instead, when a trader uses ‘limit order’, he can choose the entry point.
4. The range of a spread trade will be relative to a particular security market. It isn’t the same for all.
5. Always check the ins and outs of Bid-Ask Spread, and figure out spreads either in percentage or absolute terms for an individual security. For marginal trade, using spread trade is recommendable.
6. Bid-Ask Spread trade will come with a cost, as two trades are being conducted simultaneously.
7. In nearly all types of securities, Bid-Ask Spread trades can be conducted. But, they are most popular in the case of commodities, interest rate yields, and forex.

How Does Bid-Ask Spread Work?

One of the ways of perceiving the Bid-Ask spread is the difference between the highest price that a buyer offers and the lowest price that a seller accepts. So, if a product has a low Bid-Ask spread, it is in high demand. In sharp contrast, when an asset has a wide Bid-Ask spread, then, the volume of demand is low in all likelihood. The pricing of such a product is likely to have wider discrepancies.

When does the Bid-Ask spread become high?

At times, Bid-Ask Spread is simply known as ‘spread’. A range of factors leads to the same. This includes Liquidity, which plays a primary role.

For any security, when the amount of liquidity is significant, the spread is tighter. In particular, the heavily traded stocks, including Microsoft, Google, and Apple will have a smaller bid-ask spread.

Contrastingly, on any given day, for securities that are unpopular or unknown, the bid-ask spread may be high. A few examples of the same are small-cap stocks characterized by low trading volumes and a relatively lower demand among investors.

An example of a Bid-Ask Spread in stocks

Let us consider an instance wherein a trader intends to buy 200 shares of Microsoft for $100. The trader will consider that 200 shares are being offered at $100.10 in the market.

So, the spread will be ($100 - $100.10/200) X 100, or $0.05 wide.

In the first instance, this spread appears to be insignificant or small. But, when large trades take place, then, it can create a meaningful difference. Hence, narrow spreads are characteristically more ideal.

The total value of the Bid-Ask spread, in this case, will be 200 shares X $0.05 = $10.

Conclusion

A certain number of ways around the bid-ask spread are also there. Nevertheless, in most cases, investors will find themselves to be profitable over the long run if they stick to the proven and established system that is known to work. This could, however, take away a smaller section of their profits over time.

A few of the avenues over the internet also facilitate one to trade using a paper-trading account before they begin to use real money.

Advanced strategies may be ideal for seasoned investors, and beginners sometimes find themselves in a position worse off than from where they began. But by spending some time in the market, beginners too will get a knack for using these advanced strategies that are proven to be reasonably profitable. As a beginner, it is recommendable to play by the rules, which will keep one's money safer.