Bid Ask Spread: Meaning, Example & How it Works in Trading
When we reviewed the payment for order flow and how it works, we discovered that market makers are able to pay that to brokerage firms because usually there exists a difference between the bid and the asking price of each security. That difference gave rice to the term bid ask spread.
But what really is bid ask spread and how does it work? This and other relevant questions are what today’s blog post attempts to answer.
What Is a Bid-Ask Spread?
Bid ask spread is the difference between the bid price and the ask price for a given stock, or security. You can also refer to it as the amount with which the ask price exceeds the bid price for a given asset in the market. The bid price refers to the highest price a buyer is willing to pay for the security. While the ask price represents the lowest price a seller is willing to accept. For transaction to take place in the stock market, the bid (demand) and the ask (supply) has to meet at a point.
The bid ask spread is therefore a type of transaction cost the market maker takes as the one who facilitates the transaction. Of course, this amount is usually not static. It depends on a lot of factors, with the major factors been the time the order was executed.
Usually, the bid ask spread is a tiny percentage of the investors’ money, yet some investors care about it. And on the other hand, as little as it usually is (a few cents per stock), but it quickly adds up to substantial amount if you consider the volume of stocks market makers facilitate daily.
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How Does Bid Ask Spread Work?
In a typical financial markets, a bid ask spread is the difference between the asking price and the bidding price of a security or other asset. It represents the difference between the highest price a buyer will offer and the lowest price a seller will accept. That highest price a buyer will offer is known as ‘the bid price’. And that lowest price a seller will accept is referred to as ‘the ask price’.
From the investors perspective, an asset with a narrow bid ask spread is a better deal and it will automatically attract high demand. By contrast, assets with a wide bid-ask spread is considered not an attractive offer. The implication of that is that it will likely attract interest from very few investors.
The interesting thing here is that market makers are the key players at both the supply and the demand end. They 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). So, when an investor initiates a trade, they will accept one of these two prices depending on whether they wish to buy or sell the security.
The difference between the two prices is the principal transaction cost of trading and it is collected by the market maker. It is their reward for processing orders at the bid and ask prices.
A Workable Example
To understand this concept better, I will illustrate with a practical and relatable example.
Let’s take the bid price for a particular company stock, say Omega to be $48 and the ask price for the same stock to be $50. Then from our explanation above the bid-ask spread for the stock is $2. This value can also be expressed in percentage terms. And to do this, you simply employ the bid-ask formula.
To express the above example as a percentage, you simply divide the bid-ask difference ($2 in this case) by the ask price ($50 in this case) and multiply it by 100.
Mathematically, it will be represented as:
($2 / $50 x 100) = 4%.
What Causes a Bid-Ask Spread to Be High?
We have said that the spread can be high or low. When it is low it attracts more investors. And when it is high it typically appears less attractive.
But there are a couple of factors that usually affect the spread or that can make it to be high. Some of them are:
Trading Volume: The main factor that determines the width of the bid-ask spread is the trading volume. If large number of units or securities are being traded, the bid ask spread is low, because there are many buyers and sellers. Heavily traded stocks such as those of Google, Apple, Facebook (Meta), and Microsoft fall into this category.
on the other hand, the bid ask spread will be very high in the case of relatively unknown, or unpopular securities. These could include small-cap stocks. Of course such stocks usually have lower trading volumes.
Liquidity: Liquidity also plays a primary role in determining the width of the bid ask spread. The more liquid a market is, the lower the spread and vice versa.
Market Volatility: Another critical factor affecting the bid ask spread is market volatility. The bid-ask spread widens during times of high volatility.
Bid ask spread is the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept. This difference is the profit of the market makers and it is from it that a portion is paid to the brokerage firms as payment for order flow.
The lower the spread the more attractive the asset and therefore the demand higher. On the other hand, a high spread attracts less investors and lower demand.
Three principal factors that determine the width of the spread of any asset are:
- Trading Volume
- Market Volatility
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