CFA, FRM

Bid-Ask Spread – Complete Understanding

Bid-Ask Spread

The BID price is the price at which the market is willing to buy from us. When we talk about buying and selling Equities or Options on exchange we really don’t know to/from whom we are selling/buying from. So we will think about it as the general market. So whenever we want to sell something in the market, the BID price will be the price where we can sell it to the market.

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Similarly, ASK price is the price at which the market is willing to sell Equity/Options. So whenever we want to buy, we pay to ASK price.

Consider the below example:

Here an individual can buy forward USD/INR contract at Rs. 69.685 and if they want to sell, they will get Rs. 69.655. The difference in the BID and ASK price is BID-ASK spread. There may be several bid prices and several ask prices for a financial instrument at any point in time. However, only the best bid (that is, the highest price offered for security) and the best ask (that is, the lowest price asked for security) are used to calculate the bid-ask spread. The bid-ask spread is a reflection of the supply and demand for a particular asset. The bid represents demand and the ask represents supply for an asset.

Why BID-ASK spread matters

It is important to remember one key aspect of bid and ask prices: purchasers pay the ask price and sellers receive the bid price. Here one question arise is why securities dealers/market maker makes a profit on bid-ask spreads. Their job is to buy stocks at the bid price and sell at the ask price. Thus, the size of the bid-ask spread is directly proportional to the size of the dealer’s profit. There exist transaction costs/broker’s commission/Tax which decreases the dealer’s profit from the spread.

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Factors that determine BID-ASK spread

  • Liquidity-Volumes of some securities are very high while some securities have few trades a day. Securities that have large trading volumes will have narrower bid-ask spreads than those that are rarely traded
  • Volatility– Volatility is directionally proportional to BID-ASK spread. Higher the volatility, higher will be spread as market makers will take advantage of the situation and make a profit from it
  • Stock Price– It is observed that low price securities tend to have a wider spread. The reason for this is linked to the idea of liquidity. Most low-priced securities are either new or small in size. Therefore, the number of these securities that can be traded is limited, making them less liquid
  • Riskiness– Riskier stocks tend to have higher bid-ask spreads

Bid- Ask Spread

Impact of change in Bid-Ask Spread

  • The magnitude of the spread is an important decision variable that an investor considers in choosing a stock to buy/sell.
  • When BID-ASK spread widens, some day traders make trades that try to take advantage of the spread, and these traders prefer a large spread. Trading systems that trade the spread are collectively known as “scalping” trading systems. The traders are known as scalpers because they only want a few ticks of profit with each trade. A widespread represents a higher premium for market makers.
  • When a market is being actively traded and has high volume—a significant number of contracts being traded the spread becomes narrow.
  • Liquidity increase with the decrease in the spread

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