Quoted spread

Quoted Spread

The quoted spread is a fundamental concept within market microstructure, representing the difference between the lowest advertised selling price (the ask price) and the highest advertised buying price (the bid price) for a security at a given moment in time. This seemingly simple differential serves as a key indicator of liquidity and a primary component of transaction costs for investors in financial markets²⁸. It reflects the immediate cost an investor would incur to execute a round-trip trade, buying at the ask and immediately selling at the bid.

History and Origin

The concept of the bid-ask spread, from which the quoted spread derives, is as old as organized markets themselves, inherently linked to the role of a market maker or intermediary. These entities facilitate trade by standing ready to buy or sell, profiting from this difference. Historically, these spreads were negotiated in trading pits or over the phone.

A significant shift in how quoted spreads are observed and measured occurred with the advent of electronic trading and decimalization in the late 20th and early 21st centuries. Prior to decimalization, prices were quoted in fractions (e.g., 1/8, 1/16 of a dollar), which inherently created wider minimum spreads. The move to decimal-based pricing in the U.S. markets, for instance, allowed for much smaller increments (e.g., $0.01), leading to a significant compression of quoted spreads. This change, coupled with the rise of computerized trading and automation, enabled new forms of arbitrage and shorter-term trading, boosting market liquidity and making markets more efficient²⁷. The continuous real-time display of these bid and ask prices in electronic order book systems formalized the "quoted spread" as a transparent, observable metric for market participants.

Key Takeaways

• The quoted spread is the difference between the ask price (lowest selling price) and the bid price (highest buying price) for a security.
• It serves as a direct measure of the immediate cost of executing a small round-trip transaction.
• A narrow quoted spread generally indicates high market liquidity, while a wide spread suggests lower liquidity.
• Market makers profit from the quoted spread by buying at the bid and selling at the ask.
• Technological advancements and regulatory changes, such as decimalization, have significantly impacted the size and transparency of quoted spreads over time.

Formula and Calculation

The calculation of the quoted spread is straightforward: it is simply the difference between the prevailing ask price and the prevailing bid price.

For example, if a stock has a bid price of $50.00 and an ask price of $50.05, the quoted spread is $0.05.

Often, the quoted spread is expressed as a percentage or in basis points to allow for easier comparison across securities with different price levels. The percentage quoted spread is calculated by dividing the nominal quoted spread by the midpoint of the bid and ask prices (which serves as a proxy for the security's "true" value) and multiplying by 100:

The midpoint of the bid and ask prices is also commonly referred to as the mid-price.

Interpreting the Quoted Spread

Interpreting the quoted spread involves understanding its implications for trading costs, market liquidity, and the efficiency of price discovery. A tighter, or narrower, quoted spread indicates a highly liquid market where there is a strong consensus between buyers and sellers regarding the asset's value²⁵, ²⁶. This means that the cost of immediate execution for a market order is lower, as the difference between buying and selling prices is minimal. Conversely, a wider quoted spread suggests less liquidity, higher transaction costs, and potentially a greater divergence of opinion among market participants about the asset's fair value.

Factors that influence the size of the quoted spread include trading volume (higher volume typically leads to narrower spreads), volatility (higher volatility often results in wider spreads), and the number of market participants or market makers²⁴. In less frequently traded securities or during periods of market stress, the quoted spread tends to widen, reflecting the increased risk for market makers to facilitate trades.

Hypothetical Example

Consider a hypothetical stock, "DiversiCo Inc." (DVCO), trading on a stock exchange.

At 10:00 AM, the limit order book for DVCO shows the following:

• Best Bid Price (highest price a buyer is willing to pay): $75.20
• Best Ask Price (lowest price a seller is willing to accept): $75.25

To calculate the quoted spread:

So, the quoted spread for DiversiCo Inc. at this moment is $0.05.

Now, let's calculate the percentage quoted spread:

First, find the midpoint:

Then, calculate the percentage quoted spread:

This $0.05 (or 0.066%) quoted spread indicates the immediate cost a trader would pay if they bought one share at the ask and immediately sold it at the bid. For an investor placing a market order to buy, they would likely execute at $75.25. If they then immediately placed a market order to sell, they would execute at $75.20, effectively "crossing the spread" and incurring a $0.05 cost per share.

Practical Applications

The quoted spread is a vital metric with several practical applications across financial markets:

• Measuring Trading Costs: For individual investors and institutional traders, the quoted spread is a direct indicator of the immediate cost of executing a trade. A narrower spread means lower costs for those who demand immediate liquidity²³. This understanding directly impacts investment performance by minimizing slippage.
• Assessing Market Quality and Liquidity: Regulatory bodies and exchanges monitor quoted spreads as a key measure of market quality and the underlying liquidity of securities²². Generally, a smaller quoted spread signifies a more liquid and efficient market, where assets can be bought and sold quickly without significantly impacting prices. For example, the Federal Reserve closely monitors market liquidity as part of its monetary policy considerations, recognizing that tight liquidity can pose challenges for financial stability²¹.
• Performance Benchmarking for Market Makers: Market makers, who provide liquidity by continuously quoting bid and ask prices, earn revenue from the spread. The quoted spread is crucial for their profitability models, as it represents their potential gross profit margin on trades.
• Regulatory Oversight: Regulators, such as the U.S. Securities and Exchange Commission (SEC), utilize quoted spread data to assess the fairness and efficiency of markets. SEC Rule 605 (formerly 11Ac1-5) of Regulation NMS, for instance, requires market centers to publicly disclose detailed information on order execution quality, including data related to quoted spreads and effective spreads, enabling greater transparency and comparison across venues¹⁷, ¹⁸, ¹⁹, ²⁰.

Limitations and Criticisms

While the quoted spread is a fundamental measure in financial markets, it has certain limitations and faces criticisms:

• Static Snapshot: The quoted spread provides a static snapshot of the market at a single point in time. It doesn't account for the depth of the order book beyond the best bid and ask, meaning it doesn't reveal how much volume can be traded at those prices or at incrementally worse prices¹⁶. Large orders may "walk through" the order book, leading to an actual execution price worse than the best quoted ask (for buys) or better than the best quoted bid (for sells).
• Does Not Reflect Actual Execution Costs: The quoted spread measures the stated cost of a round-trip transaction if trades are executed at the quoted prices¹⁵. However, actual trading costs, often captured by the effective spread, can differ. Orders may receive price improvement (execution at a price better than the quoted bid for a sell, or better than the quoted ask for a buy), or they might execute at a price worse than the quoted spread due to insufficient liquidity at the best prices. The effective spread takes into account the actual transaction price relative to the midpoint, offering a more precise measure of the cost incurred by the trader¹², ¹³, ¹⁴.
• Impact of High-Frequency Trading (HFT): The proliferation of high-frequency trading (HFT) has significantly altered market dynamics and how spreads are observed and impacted. While HFT can reduce quoted spreads by increasing liquidity, enabling rapid price discovery, and making markets more efficient, it has also been linked to increased short-term volatility and potential market instability events, such as flash crashes⁹, ¹⁰, ¹¹. Critics argue that while HFT reduces explicit spreads, it introduces other complexities and potential risks, and that very narrow spreads can sometimes be misleading indicators of true market depth or resilience⁷, ⁸.

Quoted Spread vs. Effective Spread

The quoted spread and the effective spread are both measures of trading costs in financial markets, but they capture different aspects of that cost.

The quoted spread is the most straightforward measure, defined as the difference between the prevailing best ask price and the best bid price at a given moment. It represents the potential cost of an immediate round-trip trade, assuming execution occurs exactly at the displayed best bid and ask prices⁶. It is a theoretical cost based on publicly displayed quotes.

In contrast, the effective spread provides a more accurate reflection of the actual cost incurred by an investor. It is calculated based on the actual transaction price relative to the midpoint of the bid and ask prices at the time the order was submitted or executed⁴, ⁵. The effective spread accounts for factors like price improvement, where an order might be executed at a price better than the quoted offer, or market impact, where a large order might move the price beyond the initial quoted spread. The effective spread is considered a more comprehensive measure of execution quality and is often used by regulators, such as under SEC Rule 605, to assess how efficiently trades are executed², ³.

In essence, the quoted spread is what you see on the screen, while the effective spread is what you actually pay.

FAQs

What does a narrow quoted spread mean?

A narrow or tight quoted spread indicates that there is a small difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept. This typically signifies high market liquidity, meaning the asset can be bought or sold easily and quickly without causing a significant price fluctuation¹.

Why do market makers care about the quoted spread?

Market makers are financial intermediaries who facilitate trading by continuously quoting bid and ask prices. The quoted spread is their primary source of revenue; they aim to buy at the lower bid price and sell at the higher ask price, profiting from the difference. A wider quoted spread generally offers them a larger potential profit margin, while a tighter spread implies lower per-share profitability, requiring higher trading volumes to compensate.

Is the quoted spread the same as the trading commission?

No, the quoted spread is distinct from a trading commission. The quoted spread represents the implicit cost of immediacy or the difference between buy and sell prices charged by market participants providing liquidity. A commission, on the other hand, is an explicit fee charged by a broker for facilitating a trade, regardless of the spread. Both contribute to the overall cost of trading.