Relative bid ask spread

What Is Relative Bid-Ask Spread?

The relative bid-ask spread is a measure of 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), expressed as a percentage of the midpoint or ask price. It is a fundamental concept within market microstructure, providing insight into the liquidity and transaction costs associated with trading a particular asset. Unlike the absolute bid-ask spread, which is simply a dollar amount, the relative bid-ask spread allows for easier comparison of trading costs across assets with different price points. Market participants, particularly market maker entities, depend on this spread to generate revenue for facilitating trades, buying at the bid and selling at the ask¹¹. This spread is crucial for understanding the true cost of executing market orders and evaluating the efficiency of various financial instruments.

History and Origin

The concept of the bid-ask spread has been inherent in financial markets for centuries, evolving from physical trading floors where intermediaries would quote prices for immediate buying and selling. As markets became more sophisticated, especially with the advent of electronic trading, the need to quantify and analyze these spreads became more pronounced. Early theoretical models in market microstructure began to decompose the bid-ask spread into its components, such as inventory holding costs, order processing costs, and costs associated with asymmetric information¹⁰. Regulatory bodies have also played a role in shaping spread dynamics; for example, in 1993, the Securities and Exchange Commission (SEC) approved amendments to reduce excess spread parameters for Nasdaq and Consolidated Quotation Service (CQS) securities, aiming to foster a more competitive market⁹. Research into market activity and its impact on spreads, including in the options market, further developed the understanding of these crucial price differentials⁸.

Key Takeaways

• The relative bid-ask spread measures trading costs as a percentage, enabling comparison across different security prices.
• It serves as a primary source of revenue for market makers providing liquidity in financial markets.
• A narrow relative bid-ask spread generally indicates high liquidity and efficient price discovery.
• Conversely, a wider relative bid-ask spread suggests lower liquidity, higher risk, or potential information asymmetry.
• Analyzing the relative bid-ask spread is essential for investors to understand the true cost of trading and for market analysts to assess market efficiency.

Formula and Calculation

The relative bid-ask spread is calculated by dividing the absolute bid-ask spread by either the midpoint price or the ask price, then multiplying by 100 to express it as a percentage. While both midpoint and ask price are used, the midpoint is often preferred as it represents the theoretical fair value between the immediate buy and sell prices.

The formula using the midpoint price is:

Where:

• Ask Price: The lowest price a seller is willing to accept for a security.
• Bid Price: The highest price a buyer is willing to pay for a security.
• Midpoint Price: The average of the bid and ask prices, representing ( \frac{\text{Ask Price} + \text{Bid Price}}{2} ).

Alternatively, using the ask price as the denominator:

Interpreting the Relative Bid-Ask Spread

Interpreting the relative bid-ask spread provides critical insights into the trading environment for a given security. A low relative spread, often just a few basis points, suggests that the market for that asset is highly liquid, with many buyers and sellers active, and that there is a consensus on its fair value. This is typical for heavily traded assets in the stock market or major currency pairs in the foreign exchange market.

Conversely, a high relative spread indicates lower liquidity, higher trading costs, and potentially greater volatility or information asymmetry. This is often observed in less frequently traded assets, such as small-cap stocks or certain corporate bonds, where there are fewer market participants and thus a greater imbalance between supply and demand⁷. A wider spread compensates the market maker for the increased risk of holding inventory or for the difficulty in finding a counterparty quickly.

Hypothetical Example

Consider two hypothetical stocks, Stock A and Stock B.

Stock A:

• Bid Price = $100.00
• Ask Price = $100.02

Using the midpoint formula:
Absolute Spread = $100.02 - $100.00 = $0.02
Midpoint Price = ($100.02 + $100.00) / 2 = $100.01
Relative Bid-Ask Spread (Stock A) = ( \left( \frac{$0.02}{$100.01} \right) \times 100% \approx 0.02% )

Stock B:

• Bid Price = $10.00
• Ask Price = $10.03

Using the midpoint formula:
Absolute Spread = $10.03 - $10.00 = $0.03
Midpoint Price = ($10.03 + $10.00) / 2 = $10.015
Relative Bid-Ask Spread (Stock B) = ( \left( \frac{$0.03}{$10.015} \right) \times 100% \approx 0.30% )

In this example, Stock A has a lower absolute spread ($0.02 vs. $0.03), but Stock B has a significantly higher relative bid-ask spread (0.30% vs. 0.02%). This illustrates that while the absolute spread might seem small, the relative cost of trading Stock B is much higher as a percentage of its price, indicating it's likely a less liquid security. An investor placing limit orders on Stock B would need to be more mindful of this higher percentage cost.

Practical Applications

The relative bid-ask spread is a vital metric across various areas of finance:

• Trading Strategy: Traders analyze the relative bid-ask spread to evaluate the cost-effectiveness of their strategies. High-frequency traders and arbitrageurs, in particular, rely on narrow spreads for profitable execution. Investors in less liquid markets, such as the bond market, pay close attention to this metric as it can significantly impact their returns⁵, ⁶.
• Market Efficiency Assessment: Regulators and academics use the relative bid-ask spread as a key indicator of market efficiency and liquidity. A consistently narrow relative spread across a market suggests robust competition among market participants and efficient price discovery.
• Liquidity Provision: Market makers and other liquidity providers manage their exposure and pricing based on the expected relative bid-ask spread. Their willingness to quote tight spreads is inversely related to the perceived risk and volatility of an asset.
• Cost Analysis: For investors, the relative bid-ask spread represents a direct transaction costs component. Even with zero-commission brokerage accounts, investors effectively pay the spread when executing trades³, ⁴. This is particularly relevant for frequent traders or those dealing with large volumes. A research note from FINRA illustrates how analyzing bid-ask spreads, along with other metrics, helps understand liquidity provisions in markets like the corporate bond market².

Limitations and Criticisms

While the relative bid-ask spread is a valuable measure of trading costs and liquidity, it has limitations. It is a snapshot in time and can fluctuate rapidly due to market conditions, news events, or changes in order book depth. A narrow relative bid-ask spread does not guarantee that a large order can be executed at that quoted price, as market depth beyond the best bid and ask is also crucial. Furthermore, the quoted spread may not always reflect the true cost of a trade, especially in markets with advanced electronic trading systems where trades might occur "inside the spread" or benefit from price improvement. Some criticisms also arise when considering thinly traded securities where a single large order might disproportionately widen the relative bid-ask spread, making it less representative of typical trading conditions. Additionally, some academic work points out that changes in price discreteness and time elapsed between trades can technically influence observed bid-ask spreads, sometimes independently of market maker behavior¹.

Relative Bid-Ask Spread vs. Bid-Ask Spread (Absolute)

The primary difference between the relative bid-ask spread and the bid-ask spread (absolute) lies in their units of measurement and their utility for comparison.

Confusion often arises because both describe the difference between bid and ask prices. However, the relative bid-ask spread standardizes this difference, making it a more effective tool for comparing the trading costs and liquidity of a high-priced stock versus a low-priced stock or comparing different types of financial instruments. An absolute spread of $0.05 is negligible for a $1,000 stock but significant for a $1.00 stock; the relative spread clarifies this distinction immediately.

FAQs

Q: Why is the relative bid-ask spread important for individual investors?
A: For individual investors, the relative bid-ask spread represents a direct cost of trading. Even if a broker offers "zero commission," the investor still "pays" the spread by buying at the higher ask price and selling at the lower bid price. Understanding this percentage helps evaluate the true cost, especially for smaller trades or frequently traded assets, impacting overall investment returns.

Q: Does a high relative bid-ask spread always mean a bad investment?
A: Not necessarily. A high relative bid-ask spread often indicates lower liquidity for a security. While this means higher transaction costs, the investment itself might still have strong fundamentals or long-term growth potential. However, it does imply that it might be harder or more expensive to enter or exit positions quickly without impacting the price.

Q: How does increased market activity affect the relative bid-ask spread?
A: Generally, increased market activity, characterized by higher trading volumes and more participants, tends to narrow the relative bid-ask spread. This is because more competition among market makers and greater order flow lead to tighter quotes, improving liquidity and efficiency in the stock market. Conversely, low activity can lead to wider spreads.