What Is Bid-Ask Spread?
The bid-ask spread is the difference between the highest price a buyer is willing to pay for a security (the bid price) and the lowest price a seller is willing to accept (the ask price)30. This fundamental concept in market microstructure reflects the cost of transacting in financial markets and serves as a key indicator of an asset's liquidity29. When an investor places a market order to buy, they typically pay the ask price, and when they place a market order to sell, they receive the bid price. The difference between these two prices represents the profit margin for the market maker or liquidity provider facilitating the trade27, 28.
History and Origin
The concept of the bid-ask spread is as old as organized financial markets themselves, arising naturally from the need for intermediaries to facilitate trades between buyers and sellers. In earlier market structures, specialists or dealers manually quoted prices and managed their inventories, with the spread compensating them for the risk and effort involved.
A pivotal moment in the academic understanding of the bid-ask spread came with the development of the "information asymmetry" models in the 1980s. Notably, the seminal paper by Lawrence Glosten and Paul Milgrom in 1985 (preceded by their 1983 discussion paper), "Bid, Ask and Transaction Prices in a Specialist Market with Heterogeneously Informed Traders," provided a framework explaining how the spread arises from differences in information between market participants24, 25, 26. Their work demonstrated that market makers widen the bid-ask spread to protect themselves from potentially trading with informed traders who possess superior information about a security's true value22, 23.
More recently, technological advancements and regulatory changes have significantly impacted the bid-ask spread. The advent of computerized trading and the move to decimalization of stock prices in the U.S. markets in the late 1990s and early 2000s led to a substantial compression of spreads21. This shift from quoting in fractions to decimals allowed for much finer price increments, reducing the minimum possible spread to a single penny and thereby decreasing transaction cost for investors20.
Key Takeaways
- The bid-ask spread is the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask) for a security.
- It represents a direct
transaction costfor investors and a primary source of revenue for market makers. - A narrower bid-ask spread typically indicates higher
liquidityand more active trading in a security19. - Wider spreads often suggest lower liquidity, higher
volatility, or increasedinformation asymmetry18. - Understanding the bid-ask spread is crucial for assessing market efficiency and the true cost of executing trades.
Formula and Calculation
The bid-ask spread is calculated by subtracting the bid price from the ask price.
[
\text{Bid-Ask Spread} = \text{Ask Price} - \text{Bid Price}
]
For example, if the bid price for a stock is $20.00 and the ask price is $20.05, the bid-ask spread is $0.05. This can also be expressed as a percentage of the ask price or midpoint, particularly for comparing spreads across different price levels.
Interpreting the Bid-Ask Spread
The interpretation of the bid-ask spread provides crucial insights into a market's characteristics. A narrow spread signifies a highly liquid market where there are many buyers and sellers actively trading, leading to robust supply and demand and minimal price discrepancy between immediate buy and sell orders17. This is common for actively traded large-cap stocks, major foreign exchange currency pairs, and highly liquid fixed income securities.
Conversely, a wide bid-ask spread indicates lower liquidity, often found in less frequently traded securities, small-cap stocks, or during periods of high market volatility16. A larger spread means that the cost of immediate execution is higher for an investor, as they pay a greater premium to buy and receive a lower price to sell15. It can also signal greater execution risk or a lack of consensus among market participants regarding a security's fair value.
Hypothetical Example
Imagine you are looking to trade shares of Tech Innovations Inc. On your brokerage platform, you see the following quote:
- Bid Price: $49.80
- Ask Price: $50.10
Here, a buyer is willing to pay $49.80 per share, while a seller is asking for $50.10 per share. The bid-ask spread for Tech Innovations Inc. is:
If you decide to immediately buy 100 shares of Tech Innovations Inc. using a market order, you would pay the ask price of $50.10 per share, totaling $5,010. If you immediately decided to sell those 100 shares using a market order, you would receive the bid price of $49.80 per share, totaling $4,980. The $30 difference ($5,010 - $4,980) represents the cost of this round-trip transaction due to the bid-ask spread. This inherent cost is distinct from any brokerage commissions. Alternatively, you could place a limit order to buy at a lower price (e.g., $49.85) or sell at a higher price (e.g., $50.05), hoping the market moves to fill your order and potentially reducing your effective spread cost.
Practical Applications
The bid-ask spread is a critical metric across various facets of financial markets:
- Investing and Trading: For individual investors and institutional traders, the bid-ask spread is a direct component of their
transaction cost. High-frequency traders andmarket makersactively profit from managing and providingliquidityby effectively capturing the spread14. Strategies likearbitrageoften exploit temporary discrepancies in spreads across different venues or related assets. - Market Analysis: Analysts use the bid-ask spread as a real-time gauge of
market liquidityand depth. Tighter spreads generally indicate healthy, efficient markets with strongprice discovery, while widening spreads can signal deteriorating conditions or increased uncertainty13. - Regulatory Oversight: Regulatory bodies, such as the U.S. Securities and Exchange Commission (SEC), monitor bid-ask spreads to ensure fair and orderly markets. For instance, the SEC's Regulation National Market System (Reg NMS), introduced in 2005, aimed to improve price competition by requiring brokers to route orders to the venue offering the best price, which has contributed to tighter spreads for highly liquid stocks11, 12.
- Asset Valuation: In less liquid markets, such as certain private
equity marketsor obscure fixed income instruments, a wide bid-ask spread can complicate accurateasset valuationand reflect significant barriers to entry and exit.
Limitations and Criticisms
While the bid-ask spread is a crucial indicator, it has limitations. Its primary criticism stems from its direct impact on transaction cost, particularly for investors in less liquid securities. A wide bid-ask spread can significantly erode returns, especially for frequent traders or those dealing in thinly traded assets. In such cases, the cost of crossing the spread can be a substantial portion of the trade value, making immediate execution less attractive9, 10.
Furthermore, the bid-ask spread is influenced by numerous factors, including volatility, trading volume, information asymmetry, and the number of market participants8. During periods of extreme market stress or economic uncertainty, spreads can widen dramatically as market makers become more hesitant to take on risk, reflecting increased perceived execution risk and reduced market depth. For instance, research from the Federal Reserve has explored how various factors, including Federal Reserve asset purchases, can influence market liquidity premiums, which are closely tied to the bid-ask spread7. This shows that even large-scale interventions can have an impact on these underlying market characteristics, highlighting the complexity of factors influencing spreads.
Bid-Ask Spread vs. Market Liquidity
The terms bid-ask spread and market liquidity are intrinsically linked, but they are not interchangeable. The bid-ask spread is a measure or indicator of market liquidity, rather than liquidity itself. Market liquidity refers to the ease with which an asset can be bought or sold in the market without causing a significant change in its price6. A highly liquid market allows for large transactions to occur swiftly with minimal impact on the security's price.
The bid-ask spread directly reflects this concept: a narrow spread indicates high market liquidity, meaning there's a small difference between what buyers are willing to pay and sellers are willing to accept, facilitating quick and efficient trades. Conversely, a wide spread signals low market liquidity, where finding a counterparty at a mutually agreeable price is more challenging, leading to larger price concessions for immediate execution5. Therefore, while market liquidity is the overarching concept of ease of trading, the bid-ask spread is a tangible, observable metric used to quantify and assess that liquidity.
FAQs
What causes the bid-ask spread?
The bid-ask spread is primarily caused by market makers and liquidity providers who profit from facilitating trades. It compensates them for the risk they undertake in holding inventory and the potential losses from trading with better-informed participants (information asymmetry). Other factors include trading volume, volatility, and the overall supply and demand dynamics of the security4.
Is a wide or narrow bid-ask spread better?
Generally, a narrow bid-ask spread is considered better for investors as it indicates higher liquidity and lower transaction cost2, 3. A narrower spread means you pay less when buying and receive more when selling, reducing the drag on your returns. Wide spreads imply higher costs for immediate trades.
How does the bid-ask spread affect my trades?
The bid-ask spread directly impacts the price at which your market order executes. When you buy, you pay the ask price; when you sell, you receive the bid price. This difference is an immediate cost of trading. For example, if a stock has a bid of $10 and an ask of $10.05, buying immediately costs you $10.05, and selling immediately yields $10, creating a $0.05 per share round-trip cost.
What is an order book and how does it relate to the bid-ask spread?
An order book is an electronic list of buy and sell orders for a specific security, organized by price level. The highest buy orders (bids) and lowest sell orders (asks) in the order book determine the current bid and ask prices that form the spread. The depth of the order book, meaning the quantity of shares available at different price levels, also reflects market liquidity beyond just the narrowest spread1.