Bid ask spread formula
The bid ask spread refers to the difference between the lowest asking price a seller is willing to accept minus the highest bid price an interested buyer is willing to pay. The bid ask spread formula is not a complex one at all. And in this post I will attempt to simplify it in such a way that even a novice will understand it.
Bid Ask Spread Formula
The bid-ask spread is simply what is left when you take away the bid price (amount the buyer is willing to pay from the ask price (amount the seller is willing to accept).
Mathematically the bid ask spread formula can be shown as:
Usually, the bid price is always lower than the ask price. And this is very easy to explain; no seller would decline an offer price of greater value than their own requested price. The implication of this is that the bid ask spread must always be a positive value.
Moreover, the bid-ask spread can also be expressed as a percentage. And we can equally represent that mathematically as shown below:
Bid-Ask Spread Calculation with Example
I promise to explain this in such a way that a novice will understand it perfectly. In order to achieve that I will illustrate further with two examples.
Example 1
Company ABC has its shares publicly listed on an exchange. Assuming the highest bid price is $19.95 and the lowest ask price is $20.00. The share share will most likely be trading for around $19.97 or $19.98.
I am sure you are not confused as to why that have to be the case. It is rare for you to get an occasion where either the buyer or seller will completely have his or her way. There is usually a compromise from either party. And with the compromise, demand and supply tend to meet somewhere at the mid point of the bid and the ask price. It is at that point that transaction can take place. But how much it is actually trading for is not much of our concern at the moment. We simply want to get the spread, considering the highest bid and the lowest ask.
Back to the calculation:
We use the formula;
Bid-Ask Spread = Ask Price – Bid Price
Which is
- Bid-Ask Spread = $20.00 – $19.95 = $0.05
That means the bid ask spread is $0.05
We can now go ahead and express the spread as a percentage. Once again we call forth the formula we earlier established.
- Bid-Ask Spread (%) = [(Ask Price – Bid Price) ÷ (Ask Price)]*100
- Bid-Ask Spread (%) = [(20-19.95)÷(20)*100 = 0.25%
Example 2
Once again, consider Company XYZ as having its shares publicly listed on an exchange. Let’s assume that the highest bid price is $39.50. And the lowest ask price is set at $40.00.
Typically, an asset like this will eventually be trading for say, $39.75.
We use our usual bid ask spread formula;
Bid-Ask Spread = Ask Price – Bid Price
Which is
- Bid-Ask Spread = $40.00 – $39.50 = $0.50
That means the bid ask spread is $0.50.
We can now go ahead and express the spread as a percentage. Once again we call forth the formula we earlier established.
- Bid-Ask Spread (%) = [(Ask Price – Bid Price) ÷ (Ask Price)]*100
- Bid-Ask Spread (%) = [(40-39.5)÷(40)*100 = 1.25%
Wide Bid-Ask Spread Cause
Ideally, the bid-ask spread is a very tiny value. But sometimes you get a value that is relatively high. As far as investors are concerned, that is not a security to patronize. And there certain factors that are responsible for such high value. The most important ones among them are:
- Liquidity
- Volume of trade or number of market participants
Generally, the higher the liquidity and more buyers/sellers in the market — the narrower the bid-ask spread.
On the other hand, a wide bid-ask spread is indicative of low liquidity in the open markets and a limited set of buyers/sellers.
We can therefore say that:
- Wide-Bid Ask Spread → Low Liquidity and Fewer Market Participants
- Narrow-Bid Ask Spread → Higher Liquidity and More Market Participants
Popular shares like those of Apple, Meta, Google, Amazon, Tesla etc trading on popular exchange as NASDAQ are known to have lower bid ask spread.
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