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Bid-Ask Spread

Understand the Bid-Ask Spread Concept

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Bid-Ask Spread

Bid-Ask Spread Definition

The bid is indicative of the demand within the market, whereas the ask portrays the amount of supply.

The bid-ask spread equals the lowest asking price set by a seller minus the highest bid price offered by an interested buyer.

Electronic exchanges such as the NYSE or Nasdaq are responsible for matching bid and sale orders in real-time, i.e. facilitating transactions between the two parties, buyers and sellers.

  • Bids: Interest in Buying
  • Ask: Interest in Selling

Each purchase and sell order comes with a stated price and the number of applicable securities.

The orders are automatically arranged in the order book, with the highest bid ranked at the top to meet the lowest sale offer.

  • Bid Prices: Ranked from Highest to Lowest
  • Ask Prices: Ranked from Lowest to Highest

If a transaction is completed, one side must’ve accepted the opposite side’s offer — so either the buyer accepted the asking price or the seller accepted the bid price.

Bid-Ask Spread Formula

The bid-ask spread calculates the “excess” of the ask price over the bid price by subtracting the two.

Bid-Ask Spread Formula
  • Bid-Ask Spread = Ask Price – Bid Price

The bid price is always lower than the ask price, which should be intuitive since no seller would decline an offer price of greater value than their own requested price.

Moreover, the bid-ask spread is typically expressed as a percentage, where the spread is compared relative to the asking price.

Bid-Ask Spread Percentage Formula

Bid-Ask Spread (%) = (Ask Price – Bid Price) ÷ Ask Price

Bid-Ask Spread Example Calculation

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%

Wide Bid-Ask Spread Cause

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.

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Ahmed
Ahmed
March 11, 2022 4:33 am

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