The bid-ask spread is the difference between the highest offered purchase price and the lowest offered sales price for a security. Brokers often quote the spread as a percentage, calculated by dividing the bid/ask difference by either the midpoint or ask. In the case of equities, these prices represent the demand and supply for shares in the stock market. The primary determinant of bid-ask spread size is trading volume. Thinly traded stocks tend to have higher spreads. Market volatility is another important determinant of spread size. Spreads usually widen in times of high volatility.
Key Takeaways
- The bid-ask spread is the difference between the highest offered purchase price and the lowest offered sales price.
- Highly liquid securities typically have narrow spreads, while thinly traded securities usually have wider spreads.
- Bid-ask spreads usually widen in highly volatile environments.
- Traders can manage stocks with wide spreads by using limit orders, price discovery and all-or-none orders.
Trading Volume
Trading volume refers to the number of shares that exchange hands during a given period, measuring the liquidity of a stock. High-volume securities such as index exchange-traded funds (ETFs) or large-cap firms, such as Microsoft Corporation (MSFT) or General Electric Company (GE), are highly liquid with narrow spreads. Many investors look to buy or sell shares of these companies at any given time, making it easier to locate a counterparty for the best bid or ask price.
Stocks with low volumes usually have wider spreads. Small companies frequently exhibit a lower trading volume because fewer investors are interested in relatively unknown firms. Market makers often use wider bid-ask spreads on illiquid shares to offset the risk of holding low volume securities. They have a duty to ensure efficient functioning markets by providing liquidity. A wider spread represents higher premiums for market makers.
Volatility
Volatility measures the severity of price changes for a security. When volatility is high, price changes are drastic. Bid-ask spreads usually widen in highly volatile environments, as investors and market makers attempt to take advantage of agitated market conditions.
How to Trade Stocks with Wide Bid/Ask Spreads
Use Limit Orders: Instead of blindly entering a market order for immediate execution, place a limit order to avoid paying excessive spreads. Let’s assume David wants to purchase a small-cap stock and the best bid is 30 cents, while the best offer is 50 cents. David could enter a buy limit order at 31 cents, which sits at the top of the bid giving him priority over all other buyers. Alternatively, if David was a seller, he could place a sell limit order at the top of the offer at 49 cents.
Price Discovery: Often, stocks that have wide spreads trade infrequently. Even if a trader uses limit orders, they can sit on the bid or ask for days without getting executed. Test out the market by incrementally increasing the buy limit price and decreasing the sell limit price. For example, If Emily currently sits at the top of the bid at $1.00 and the best offer is $1.25, she could perform price discovery by raising her limit order by 5 cents each day for a week to test the willingness of a seller to come down to her bid price.
Avoid All-or-None Orders: These orders specify that the total number of shares bought or sold gets executed, or none of them do. In wide bid/ask markets, liquidity is often thin, meaning a trader could miss out on acquiring shares if only small parcels of stock get traded. For instance, if Tom has placed an all-or-none buy limit order for 5,000 shares at $1.00 and a seller enters the market with 4,999 shares to offload at the bid price, the trade wouldn't execute due to a shortage of units to fill Tom's order in its entirety i.e., one share short.
FAQs
The bid-ask spread is the difference between the highest offered purchase price and the lowest offered sales price. Highly liquid securities typically have narrow spreads, while thinly traded securities usually have wider spreads. Bid-ask spreads usually widen in highly volatile environments.
What does a big difference between bid and ask price mean? ›
Markets with a wide bid-ask spread are typically less liquid than markets with a narrow spread. The spread widens because there aren't high levels of supply and demand, or buy and sell orders to easily match up.
What stock market term reflects the difference between the ask and the bid? ›
The difference between the bid and ask prices is referred to as the bid-ask spread. The bid-ask spread benefits the market maker and represents the market maker's profit. It is an important factor to take into consideration when trading securities, as it is essentially a hidden cost that is incurred during trading.
When selling options What is the difference between bid and ask? ›
Key Takeaways
The bid price refers to the highest price a buyer will pay for a security. The ask price refers to the lowest price a seller will accept for a security. The difference between these two prices is known as the spread; the smaller the spread, the greater the liquidity of the given security.
What is the difference between bid and ask on Etrade? ›
The ask (or offer) price, which displays in the green font, is the price at which the dealer is willing to sell their bonds. The bid price, which displays in the red font, is the price at which the dealer is willing to purchase the bond.
Why is there a gap between bid and ask? ›
The primary determinant of bid-ask spread size is trading volume. Thinly traded stocks tend to have higher spreads. Market volatility is another important determinant of spread size. Spreads usually widen in times of high volatility.
What if bid is higher than ask? ›
When the bid volume is higher than the ask volume, the selling is stronger, and the price is more likely to move down than up. When the ask volume is higher than the bid volume, the buying is stronger, and the price is more likely to move up than down .
What term is used to describe the difference between the bid and the ask? ›
The difference between the bid price and the ask price is called the "spread."
Do you buy stocks at the bid or ask price? ›
The ask price is the lowest price that a seller will accept. The difference between the bid and ask prices is called the spread. The higher the spread, the lower the liquidity. A trade will only occur when someone is willing to sell the security at the bid price, or buy it at the ask price.
What is the difference between bid and ask price for silver? ›
The bid (or buy as a layman's term) is the price at which market participants, such as Tavex, are ready to buy gold or silver at any given time. The ask (or sell as a layman's term) is the price at which market participants, such as Tavex, are ready to sell gold or silver at any given time.
The Bid is the price that a buyer is willing to pay for the stock. This price is almost always lower than the Ask. The Ask is the price the seller is willing to sell the stock for. In a perfect world, we would be able to buy the stock at the Bid price, but that's rarely possible.
What is the best bid and best ask? ›
On the buy side of the market, available prices are always shown in decreasing order. The top price is always deemed the best possible bid price. On the sell side of the market, available prices are always shown in increasing order. The top price is always deemed the best possible ask price.
What is a good bid-ask spread? ›
A narrow bid/ask spread typically indicates good liquidity. Pay attention to the liquidity, because illiquid options with a wide bid/ask spread can cut into your potential profits, among other issues. Imagine an options contract with a $. 75 bid and a $1.00 ask.
What is the difference between ask and bid on Schwab? ›
Bid: Tells you the highest price at which a buyer is willing to pay to purchase a stock. Ask: Tells you the lowest price at which a seller is willing to sell their shares. Beyond this, most information surrounding your trading dashboard may seem self-explanatory. Other terms, however, may be completely unfamiliar.
What is the difference between bid and ask on Ameritrade? ›
The bid is the best price somebody will pay for shares (and where you can sell them), and the ask is the best price somebody will sell shares (and where you can buy them). The bid size and ask size indicate how many aggregate shares are available at each of those prices, respectively.
What is the difference between bid and ask on FX? ›
Bid-Ask Spreads in the Retail Forex Market
The bid price is what the dealer is willing to pay for a currency, while the ask price is the rate at which a dealer will sell the same currency.
Do I buy at the bid or ask price? ›
The term "bid" refers to the highest price a buyer will pay to buy a specified number of shares of a stock at any given time. The term "ask" refers to the lowest price at which a seller will sell the stock. The bid price will almost always be lower than the ask or “offer,” price.
What happens when bid price is lower than ask price? ›
The difference between the (lower) bid and (higher) ask is called the “bid-ask spread,” and is nearly always present in liquid markets. How is this possible? If the bid is lower than the ask, then no trade will take place because the seller is demanding a higher price than what the buyer is willing to pay.
Why is the asked price higher than the bid price? ›
Typically, the ask price of a security should be higher than the bid price. This can be attributed to the expected behavior that an investor will not sell a security (asking price) for lower than the price they are willing to pay for it (bidding price).
What are best ask and best bid prices? ›
The highest price that someone is willing to buy a crypto at is known as the “best bid“. This best bid price guarantees the highest possible price for any seller at that particular time. The lowest possible price that someone is willing to sell at is called the “best ask” or “best offer”.
