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08:39, 6 July 2017

The bid-ask spread is the difference between the ask price and the bid price of an asset. Ask (the offer) is the minimum price a seller agrees to accept for a security, while bid is the highest price a buyer agrees to pay. The offer price of a stock, commodity, index or foreign currency always exceeds the bid price.

Why do investors have to consider the spread? In addition to commissions and fees, brokers have other charges, and bid-ask spread percentage is one of them. By knowing how to measure it, you’ll be aware of the true costs of your transaction.

Let's check how it works and insert figures into the formula right away. Assume the stock of company CPTL trades at \$19.95 (Bid)/ \$20 (Ask). Therefore bid-ask spread is \$20 – \$19.95 = \$0.05. As a percentage, this makes (\$20 – \$19.95) / \$20 * 100% = 0.25%. In other words, if you bought one CPTL share at \$20 and then sold it immediately at \$19.95 (a loss of \$0.05), you would lose 0.25% on the transaction.

Now, imagine that instead of one share, you buy and sell 100 shares at \$19.95/\$20. You’ll incur a loss of (\$20 – \$19.95) * 100 = \$5. In the same transaction involving 1,000 shares the loss will make \$50. However, in all the examples above the percentage loss from the spread will be the same – 0.25%.

Consequently, evaluating spread percentages is one of the investors’ major concerns, especially when they trade on margin. Remember, percentages can be deceiving, note that in percentage terms, a 0.5% spread on a \$20 stock is bigger than a 0.5% spread on a \$40 stock.

What is the bid-ask spread dependent on? Liquidity as well supply-demand relation influence the spread most. The more traded an asset is, the narrower spread it has. However, if the supply-demand relation is greatly unbalanced, spreads will tend to widen.

The bottom line

The bid-ask spread is a one of the hidden costs an investor incurs. When trading any security, carefully consider the spread in percentage terms to be aware of the transaction costs when you buy or sell.