What is a bid-ask spread?
The stock market operates like an auction where investors buy or trade securities. The buyer states how much they are willing to pay for the security, which is the bid price, and the seller sets their own price, known as the ask price.
The bid-ask spread is the difference between the ask and the bid price of the security. Ask, or the offer price of a stock, index, commodity or cryptocurrency always exceeds the bid price.
Why is the bid and ask spread one of the major notions in trading? If you use an online trading platform, or a trading broker, you usually pay certain commissions and fees and bid-ask spread is one of them. Actually, the bid-ask spread is the major transaction cost, which is collected by the broker for processing clients’ orders at the bid and ask prices.
To learn the exact cost of your transaction, you should understand and learn how to calculate the bid-ask spread for any asset you want to trade.
Bid-ask spread explained
The bid-ask spread can be seen as a measure of supply and demand for a certain asset on the market. De facto, it is the measure of the market’s liquidity.
The size of the bid-ask spread differs from one instrument to another due to the difference in liquidity. Certain markets have always been more liquid, i.e. more popular among traders and investors, which is reflected in lower spreads.
Calculating the bid-ask spread is pretty simple: you should subtract Bid from Ask. To find out the spread percentage, use the following bid ask spread formula:
Bid-ask spread (%) = (Ask – Bid)/Ask x 100%
For example, forex markets are considered the most liquid in the world offering one of the smallest bid-ask spread percentages for various currency pairs. The spreads for liquid assets can be measured in fractions of pennies. However, less liquid assets, such as stocks with a small market capitalisation, could have spreads of 1 or 2 per cent.
Let’s calculate the bid-ask spread on a simple example. Imagine that the stock’s bid price is $49 and the ask price for the same stock is $50. We can say that the bid-ask spread for this stock is $1. If we calculate this spread in percentage terms we will get (50 – 49)/50 x 100% = 0.02%.
The bid-ask spread represents one of the hidden costs an investor bears. Always mind the spread to know the exact cost of your trades.