If you’re new to trading it is likely that you’ve come across the term “bid-ask spread”. A bid-ask spread provides a good measure of the market’s liquidity and in simple terms refers to when the ask price for an asset exceeds the bid price when trading. It’s important for traders to consider the bid-ask spread when buying or selling an asset as it affects the profitability of their trades.
In this article, we break this concept down along with bid price and ask price, and explore how they work and why it's relevant.
Bid price and ask price definitions
Before we get started, let's cover what the terms bid price and ask price mean.
Bid price
The bid price is the highest price that a buyer is willing to pay for a financial asset, such as a stock or a currency pair. It is the price at which a buyer is willing to purchase the asset from the seller. In other words, the bid price represents the demand for the asset, as buyers are willing to pay this price to acquire it.
Ask price
The ask price is the lowest selling price that a seller is willing to accept for an asset. It represents the price that a seller is willing to sell the asset to a buyer. The ask price represents the supply of market, as sellers are willing to offer it at this price.
What is a bid-ask spread?
As touched on above, a bid is the highest price a buyer is willing to pay for an asset, indicating the demand in the market, while the ask is the lowest price a seller is willing to accept, indicating the supply.
The bid-ask spread, therefore, refers to the difference between the bid price and ask price and represents the profit margin for market makers and other intermediaries who facilitate trades in the financial markets.
The bid-ask spread is a fundamental concept in trading, as it represents how liquid the market is. A narrow bid-ask spread indicates a more liquid market with tighter competition, while a wider spread indicates a less liquid market with fewer buyers and sellers.
How bid-ask spreads work
Market makers, many of which are employed by brokerages, process orders for traders and collect the spread (more on this below). This is often referred to by brokerages as “crossing the spread”, a means by which the business earns revenue.
The bid-ask spread represents a reflection of the supply and demand for an asset. If there are more people who want to buy than sell, this equates to a narrow bid-ask spread, while a wide bid-ask spread will indicate a less liquid market.
The depth of the bids and asks can affect the spread, and traders need to be aware of the spread when placing orders. Sometimes, market makers will widen the spread to protect themselves from risk, and some traders try to make money by exploiting changes in the spread.
Example of how a bid price and ask price works
Say a stock price is listed on an exchange with a bid price of $50 and an ask price of $55, this makes the bid-ask spread $5. This value might also be presented in percentage form, calculated as a percentage of the lowest ask or bid price.
This would be calculated by dividing the bid-ask spread by the lowest ask price. In this case, $5 divided by $50 multiplied by 100.
$5 / $50 x 100 = 10%
This spread would close if a seller offered to sell that stock at a lower price or a buyer offered to purchase the stock at a higher price. This value would then be collected by the market maker.
What are market makers?
A market maker is a financial firm or individual that facilitates the buying and selling of financial instruments in a particular market. Market makers are typically investment banks, brokerage firms, or other financial institutions that maintain an inventory of certain financial assets and are willing to buy and sell these assets at publicly quoted prices.
Market makers provide liquidity to a financial market by offering to buy and sell financial assets at prices that are close to the current market price. They do this by quoting both a buy and a sell price for the assets they trade, and they make a profit by buying assets at a lower price than they sell them for.
Market makers play a crucial role in financial markets, as they ensure that there is a continuous supply of buyers and sellers for financial assets, even during times of market volatility or uncertainty. This helps to keep prices stable and reduces the risk of market disruption or illiquidity.
Bid-ask spreads and market liquidity
The degree of bid-ask spread differs across various assets due to their varying liquidity. The more liquid an asset is in the market, the lower the bid-ask spread. Take currencies for example, due to their highly liquid market they have one of the smallest spreads in the industry. Metals on the other hand, like platinum, have a wider bid-ask spread due to lower trading volumes.
Less liquid assets will therefore have a higher bid-ask spread, often indicating to professional investors that it is a more risky asset.
In conclusion
The bid-ask spread is a concept used in trading that indicates the gap between the maximum price that a buyer is willing to offer for an asset and the minimum price that a seller is ready to take. The bid-ask spread also reflects how liquid the market is, indicating how many buyers and sellers that particular asset has.
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