Bid-Ask Spread

Bid-Ask Spread Calculation Example

Suppose a company’s shares are publicly listed on an exchange and trading at $24.95 per share.

The highest bid price is stated as $24.90, and the lowest ask price is set at $25.00, which is why the current share price reflects the “mid-point” between the highest bid and lowest ask price.

Given those two figures, the bid-ask spread equals the difference, $0.10.

• Bid-Ask Spread = $25.00 – $24.90 = $0.10

We can now express the spread as a percentage by dividing the spread of ten cents by the ask price, which comes out to 0.40%.

• Bid-Ask Spread (%) = $0.10 ÷ $25.00 = 0.40%

What Causes a Wide Bid-Ask Spread?

The primary determinant of the bid-ask spread is the liquidity of the security and the number of market participants.

Generally, the higher the liquidity — i.e. frequent trading volume and more buyers/sellers in the market — the narrower the bid-ask spread.

For example, a public company such as Apple (NASDAQ: AAPL) would have a substantially narrower bid-ask spread than a thinly-traded, small-cap company.

On the other hand, a wide bid-ask spread is indicative of low liquidity in the open markets and a limited set of buyers/sellers.

Liquidity risk refers to the potential for a seller to incur monetary losses from being incapable of converting the investment into cash proceeds, i.e. the uncertainty in pricing from a lack of buyer demand.

• Wide-Bid Ask Spread → Low Liquidity and Fewer Market Participants
• Narrow-Bid Ask Spread → Higher Liquidity and More Market Participants

For instance, an artwork worth millions most likely carries a wide bid-ask spread, so there is significant liquidity risk due to the low number of potential buyers.

The distance between the bid-ask spread is theoretically a profit or loss, depending on whichever viewpoint you’re looking from.

• If a buyer places a market order, the purchase is made at the lowest sale price.
• Conversely, the sale is made at the highest bid if a seller places a market order.

In effect, a wide bid-ask spread brings in the risk that buyers overpaid or sellers exited their positions at too low of a price (and missed out on profits).

Hence, investors are recommended to utilize limit orders when the bid-ask spread is wide rather than placing market orders to mitigate the risk of immediate paper losses after the transaction closes.