What is the bid / ask spread?
Chapter 1: Intro
When you hear people talking about ‘the market’, they typically mean more than one thing. That’s because ‘the market’ is a broad collection of financial services, products and instruments – and each offers a bewildering variety of opportunity and risk.
This is also why you’ll often hear news bulletins finishing with “and shares were up (or down) such-and-such” suggesting the confidence or volatility in the market.
Put simply, ‘the market’ is where companies, commodities and services are bought and sold. From company stocks, where you can purchase tiny chunks of companies – and whose value will rise or fall (sometimes as a result of good or bad economic or company news; to bonds, which are more like simple IOUs, usually have a fixed payback date and are generally considered safer.
Whatever they’re buying or selling, the market is the place where buyers and sellers come together. Sometimes that’s electronically and under one roof, like the London Stock Exchange. Or it could be via trading over the counter (OTC).
(The OTC market has fewer rules and may not have a physical base. Much of the trouble in the financial markets between 2007 & 2008 came from higher risk OTC products.)
One of the first things you’ll notice about the market is the language. It sometimes feels that the world of financial markets has its own dictionary – and you’ll find a lot of strange jargon bubbling about. Though expressions like ‘bull’ and ‘bear’: are easy enough to grasp, other terms need a bit of explanation. Let’s look at a few of these…
Chapter 2: What is ‘the spread’?
The simplest answer is that ‘the spread’ is the difference between the buying and the selling price. Think of a used car dealer making a profit on the price they offer you on your part-exchange and the price they charge the new owner when they sell your old car on.
In reality, though, ‘spread’ can have a number of subtler meanings. For example, there’s the ‘bid’ and ‘ask’ spread (aka the bid-offer spread) - which is how the price of a security is negotiated. The ‘bid’ price is the top price a buyer says they’re willing to pay. The ‘ask’ price is the top price a seller hopes for. Between these two numbers a price is agreed.
Standing in the middle of this conversation is the broker. They make a living from the bid and ask difference. However, the spread can contain a number of other fees or costs. It’s not always pure profit for the broker!
Chapter 3: What affects the spread?
That usual suspect: supply and demand. The spread can also widen in volatile times (when the number of sellers might outstrip the number of buyers). Whereas if you’re buying shares that are bought and sold regularly and in demand, the spread can be low.
The spread is almost always fluctuating as traders and investors respond to new information. For example, you might hear someone talk about the ‘spread’ of a stock price during a trading period – be it a week or three days. “The spread on X stock was smaller than I expected.”
Bear in mind that low volume stocks can have a wider spread because they may not be bought and sold very much. And for some shares, the bid and ask difference tends not to vary much. That’s because some shares are highly researched, and their performance is consistent… well, usually!
If you’re day trading, the bid and ask spread is critical because the difference can have a big impact on your daily profits. Also bear in mind that if you’re watching the price of a stock on a website, you’re only seeing the price of what was last paid for it. You may pay higher or lower if you take the plunge and buy.
Mind the gap!
The difference between the ‘bid’ and the ‘ask’ spread has narrowed over the years for investors. This is partly because of technology and rising demand, helping drive costs down. That means more of what you invest ultimately goes into long-term stock market performance.
Checklist: what affects the spread?
• Availability – how widely and easily the shares of a company can be traded
• Volume – if the amount of shares is changing hands quickly
• Popularity – high-priced shares can have a large spread
• Market volatility – both bad and good news, economic and company-specific