Have you ever noticed why you pay slightly different prices when buying and selling assets? That gap, known as the bid-ask spread, reflects the risk involved.

Imagine two options: a hot, volatile Low Cap Stock and a stable blue-chip stock. Both might be priced at $5, but the crypto's buy price might be lower (e.g., $4.85), while the stock's buy price sits closer to $5 (e.g., $4.95).

This difference?

The bid-ask spread!

It's more comprehensive for the riskier crypto, reflecting the uncertainty buyers and sellers have about its future value.

In contrast,

the stable stock's tighter Spread indicates lower risk and smoother transactions.

The "spread" or "bid-ask spread" is a crucial concept in the stock market. But not everyone might be familiar with it or understand how it impacts their investments.

In the blog post below, we will try to understand what it is and then analyze how it affects trading decisions.

What is a Bid/Ask Spread?

The bid/ask spread, or the bid-ask spread, is the difference between the highest price someone is willing to pay (bid) for an asset and the lowest price someone is willing to sell (ask) it for. In simpler terms, it's the transaction cost associated with buying or selling that asset.

Here's a breakdown:

• Bid: The highest price a buyer currently offers to purchase an asset.
• Ask: The lowest price a seller offers presently to sell an asset.
• Spread: The difference between the bid and ask price.

Why is the Spread important?

Knowing about the Bid/Ask Spread is important because

It affects your profits

A wider spread means a more significant chunk of your potential profit gets eaten up by transaction costs.

It also reflects liquidity.

A narrower spread usually suggests higher liquidity, meaning more buyers and sellers are willing to participate, leading to smoother transactions.

It can also offer trading opportunities.

Savvy traders can use the Spread to identify arbitrage opportunities, where they buy an asset at the bid price in one market and sell it at the ask price in another, pocketing the difference.

How the BID/ASK spread works:

The Bid/Ask Spread works on one of the most fundamental concepts of Economics, "The Concept of Supply and Demand."

“Supply” is how much of something is available, such as stocks for sale.

While Demand is about how much someone is willing to pay for that thing or stock.

Now,

The bid-ask spread reveals where buyers and sellers are hanging out. A small spread means the stock is busy with many buyers and sellers, making it easy to trade. But if the Spread is significant, the stock might be less popular.

When there's a big gap between supply and Demand, and only a few people are trading, the bid-ask spread gets wider.

And this is precisely what you notice in the stocks of big companies,

Famous stocks like Apple, Netflix, or Google usually have a small spread because many people are trading them. However, the Spread might be more comprehensive for less popular stocks because only a few buy or sell them.

Example:

For instance, trader A wants to buy 1,000 shares of XYZ stock at $10, and there is another trader, trader B, who wants to sell 1,500 shares at $10.25. The Spread is the difference between what Trader B is asking ($10.25) and what Trader A is bidding ($10), which is 25 cents.

If you're a regular investor and see this, you could sell 1,000 shares at $10 to Trader A or buy 1,500 shares at $10.25 from Trader B.

The Spread and the stock price depend on how many people want to buy or sell. More buyers mean more bids and more sellers mean more asks. The balance between buyers and sellers determines the Spread and the stock price!

Factors affecting the BID/ASK spread:

Many factors affect your BID/ASK Spread. Let's discuss them one by one.

1.     Liquidity:

Stocks having higher liquidity means more buyers and sellers actively participate in the market, leading to tighter spreads as competition drives prices closer together. For example, widely traded blue-chip stocks typically have narrower spreads than thinly traded penny stocks.

On the other hand,

Lower liquidity Stocks mean fewer participants, creating a less competitive environment. This allows market makers to widen the Spread to compensate for increased risk and uncertainty in finding a counterparty. This is often seen in smaller markets or less popular assets.

2. Trading Volume:

Higher trading volume is directly linked to greater liquidity. More orders on the buy and sell side create tighter spreads as competition keeps prices closer together. 

Conversely, 

Lower volume translates to lower liquidity and wider spreads, similar to the dynamic we discussed earlier.

3.     Volatility:

Assets with Higher volatility are inherently riskier, leading to wider spreads. This happens because the market makers attempt to price in potential future movements. Volatile cryptocurrencies are a prime example.

On the other hand,

Lower volatility assets with predictable price movements generally have tighter spreads due to lower uncertainty and risk of adverse price changes. Government bonds typically exhibit low volatility and narrow spreads.

4.     Asset Type: 

The Bid/ask Spread also depends on the asset type.

Different asset classes have different risk profiles and trading characteristics, leading to varying typical spreads.

a.    Stocks: Spreads often vary based on market capitalization, with large-cap stocks having tighter spreads than small-cap or penny stocks.

b.    Bonds: Government bonds usually offer narrow spreads due to low risk and high liquidity. Corporate bonds, on the other hand, exhibit wider spreads based on issuer creditworthiness and market conditions.

c.     Options: Option contracts have spreads built into their pricing structure, considering factors like time to expiration, underlying asset volatility, and implied volatility.

d.    Cryptocurrencies: Spreads in crypto markets can be significantly more comprehensive than other asset classes due to their inherent volatility, lower regulation, and less established infrastructure.

5.     Other Factors

Apart from the factors mentioned above, there are other factors as well which can impact the bid/ask spread;

One of them is the Order size.

Market makers might widen the Spread for sizeable transactions, especially in less liquid markets, to compensate for the increased risk and potential impact on market depth. Smaller trades are less disruptive and often enjoy tighter spreads.

The Bid/Ask spread is also dependent on the Market conditions

Periods of high market stress or uncertainty can lead to wider spreads across various asset classes as liquidity dries and volatility increases, making market-making activities riskier. Think of economic crises or significant news events.

During calmer periods, spreads tend to be tighter due to increased liquidity and lower perceived risk.

Why you should care about the BID/ASK spread:

Here are some key reasons why you should care about the bid-ask spread:

1. It directly impacts your transaction cost:

The bid-ask spread represents the difference between the highest price someone is willing to pay (bid) and the lowest price someone is willing to sell (ask) for an asset. You're paying this Spread as a transaction fee when you buy or sell. A wider spread means a higher cost, impacting potential profits or losses.

2. It reflects the risk of the asset:

As we have mentioned above, riskier assets generally have wider spreads. This is because market makers need to be compensated for the increased uncertainty of finding a counterparty at the desired price. Understanding the Spread can help you gauge the inherent risk of trading a particular asset.

3. It signals market depth and liquidity:

Tighter spreads generally indicate higher liquidity, meaning more buyers and sellers actively participate in the market. This translates to faster and smoother execution of your trades. Wider spreads, on the other hand, signify a less liquid market where finding a matching order might be more challenging.

4. It can refine your trading strategy:

Understanding the bid-ask spread can help you refine your trading strategies. For example, suppose you're a day trader focusing on short-term profits. In that case, you might prioritize assets with tighter spreads to minimize transaction costs. Conversely, think you're a long-term investor holding assets for more extended periods. In that case, wider spreads might be less of a concern.

Impact of Bid/Ask Spread on Different Order Types (With Examples)

Now, this is an interesting aspect to consider

While the bid-ask spread is inherent to trading, different order types can interact with it uniquely, impacting your transaction costs and overall trading strategy. Let's dive into some standard order types and their spread implications:

If you want to know more about the Different Order types, Our Blog, Stock Market Orders: Types & How to Manage Risk with Them, might be an excellent point to start with

1. Market order:

Impact: Widens the Spread.

Example: You place a market order to buy 100 shares of XYZ stock at any available price. The order immediately eats through existing buy orders at the ask price, potentially pushing it higher to fulfill your entire order. This creates a temporary imbalance favoring sellers, widening the Spread.

2. Limit order:

Impact: No immediate impact, but potential future impact.

Example: You order a limit to buy 100 shares of XYZ at $10 or less. This order doesn't affect the current Spread unless it falls within the existing Spread and matches with a sell order. However, many limit orders accumulate at a specific price point. In that case, they can create buying pressure, potentially tightening the Spread in the future.

3. Stop-loss order:

Impact: Widens the Spread in volatile markets.

Example: You place a stop-loss order to sell XYZ if the price drops below $9. This order sits dormant until triggered. If the market suddenly crashes, a surge of stop-loss orders could flood the market, increasing supply and widening the Spread to sell quickly.

But Remember

These are just examples, and the actual impact of each order type depends on various factors like order size, market depth, volatility, and overall trading activity.

Conclusion:

The bid-ask spread is a crucial aspect of the market, though seemingly a minor detail. It reflects the constant negotiation between buyers and sellers, dictating the cost of entering and exiting your investments.

By recognizing its role in liquidity, volatility, and transaction costs, you gain a deeper understanding of the market landscape, enabling you to make informed decisions. Remember, every trade starts and ends with the Spread, so

Remember not to underestimate its power!

&

Trade Smarter!

Frequently Asked Questions (FAQs)