Virtually every transaction has a buyer and seller. The buyer is an individual or institution that wants to buy a security while the seller already owns a security and hopes to turn it into some cash.
In the stock market, a buyer can set the highest amount they are willing to pay for an asset. A seller can also set the lowest he or she is willing to go to relinquish the asset. The bid is the highest price a buyer is willing to pay for a security and the ask is the lowest price for which an asset is currently available on the market.
Understanding the bid-ask spread is crucial in getting the best price for a security, either as a buyer or a seller, as we shall find out below.
What is Bid-Ask Spread?
As mentioned earlier, the bid price is the highest price a buyer is willing to pay to acquire an asset while the ask price is the lowest price a seller can accept for an asset. The bid-ask spread is the difference between the bid price and ask price.
The ask price is usually higher than the bid price. Traders must negotiate back and forth until the two hammer out the same price for a particular security. The remaining buyers and sellers continue with the negotiations until the next pair settles on a price. And the dance continues. If a pair can’t agree on the price, the order won’t go through.
Bid-ask prices also give a wider picture of the overall trading activity — they are what buyers and sellers want but there’s no guarantee of getting that price. However, knowing the bid-ask prices is crucial in knowing what price to set so that your order is fulfilled.
For instance, if you’re looking to enter a position immediately, you’d set your bid price to match the ask price. Similarly, if you want to exit a stock position quickly, you would execute an order at the current bid price. Matching the current offer price will most certainly trigger an immediate transaction rather than waiting for a price that favors you.
The stock market, options, futures contracts, and foreign currencies all have bid-ask spreads. Investors often use spreads to assess a stock’s liquidity — how fast you can enter or exit a position — since wider spreads often indicate less liquid securities.
What Determines Bid-Ask Spread?
Several factors contribute to the difference between the bid and ask prices as follows:
Trading volume is a crucial factor in determining the bid-ask spread, and it’s often tied to liquidity. A rule common to all financial instruments is that the larger the trading volume, the lower the bid-ask spread will be. A higher trading volume translates into more buyers and sellers in the market, which increases the likelihood of finding willing buyers and sellers at any instance.
When buyers are more eager to purchase, the higher the prices they’ll offer. Sellers will also accept the lowest prices when they are eager to unload a security. The result of higher trading volumes in a market is narrow spreads, and the contrary is also true.
Supply and Demand
With the bid-ask spread signaling levels at which buyers and sellers will sell, the supply and demand of a security affect its spread. Demand is the willingness of an individual to pay a particular price for a stock. Supply is the abundance or volume of a security in the marketplace.
When there’s a significant demand or supply imbalance, the spread will widen substantially. A narrow spread indicates an actively traded stock with high liquidity. In this case, popular stocks will have lower bid-ask spreads while securities that are not readily traded may portray wider spreads.
Another aspect that impacts the bid-ask spread is volatility, and it’s often tied to uncertainty in the market. Volatility typically increases in periods of uncertainty, market advancement or decline. During such times, the bid-ask spread tends to increase since market makers are looking to take advantage and profit from the situation. Traders often dislike periods of uncertainty and may scale back their trading activity until the dust settles. Fewer active traders will lead to a wider spread.
When the volatility is low, and levels of risk and uncertainty at a minimum, more traders are attracted to the market, which results in a narrow bid-ask spread.
Institutional investors are often willing to pay more when securities are increasing in value, which gives market makers a chance to charge higher premiums.
How Spreads Affect the Market
Although the bid-ask spread terminology seems to create a stalemate between buyers and sellers, it equally impacts the market.
Spreads may affect the price at which you buy or sell a security. When spreads are narrower, buyers are more likely to get better prices on a security since sellers can’t go too high with their ask prices. With narrow spreads, buyers are also able to quote lower bids since there’s more market trading activity.
When spreads are wide, sellers have the advantage — they can quote high ask prices in a move to profit from the huge price difference. With no one looking to sell, buyers will need to pay more money to get their orders fulfilled.
Advantages of Bid-Ask Spread
One benefit of the bid-ask spread is that it helps traders minimize risks. If you’re keen on entering or exiting the market fast, you can monitor the bid-ask spread, since tighter spreads indicate higher stock liquidity. In such a case, it can be easier for you to get in and out of a position immediately, which reduces your overall risk.
You can also benefit from the bid-ask spread by executing these types of orders:
- Market order. A market order is an instruction to buy or sell a security immediately. While there’s never a guarantee to the price at which your trade will execute, the bid-ask spread helps ensure that your market order is executed at or close to the current bid-ask level.
- Limit order. A limit order lets you buy and sell stocks at a specific price or higher. You should understand the intricacies of limit orders since buy limit orders, for instance, execute at or lower than the stock’s limit price.
- Stop order. A stop order is an instruction to buy or sell a stock after it attains a specific price level, called the stop price. Your trade will execute as soon as the order hits the stop price, usually as a limit order.
Read More: Beginner’s Guide to Stock Order Types
Why Bid-Ask Spread is Especially Important for Day Traders
Studying the bid-ask spread is a clever move for every investor and trader — but it can be incredibly useful to day traders. First, the bid-ask spread may give traders an indication of which way the stock price is likely to move in the short term, which may help in identifying better traders or avoid losses altogether.
Day traders must also be conversant with the costs of placing trades, including brokerage fees as well as entry and exit prices for trades. Monitoring spreads may potentially aid day traders in securing better entry and exit prices.
It’s important that day traders trade stocks when there’s sufficient liquidity to enter and exit a position fast. The bid-ask spread can give day traders an indication of the liquidity levels and how easy it is to trade securities.
How to Trade with the Bid-Ask Spread
Here are a few ways through which traders can incorporate the bid-ask spread into their trading strategy:
- Low float stocks. If you mainly trade penny and small-cap stocks, then you’re primarily dealing with low float stocks that carry lower trading volumes. In this case, it’s important that you monitor the liquidity of such stocks just so that you don’t get trapped in a position you can’t close quickly.
- Watchlists. You can use the bid-ask spread to create a watchlist of stocks with the tightest spreads. This way, you can figure out what securities to open positions in and the best trading strategy for your list.
- Buying and selling at the bid-ask price. It’s easier to enter and exit positions at the bid-ask price since there are more buyers and sellers willing to execute a trade.
The bid-ask spread is just as crucial a factor in stock trading — it’s where the rubber meets the road and orders are executed. However, traders of all experience levels must be comfortable with the intricacies of the bid-ask spread. But again, it’s just one cog in your overall trading strategy.
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