What is the bid-ask spread and what does it mean?

You might have come across the claim, “This broker does not charge commissions.” But how is that possible? Below, we’ll unravel the concept of bid-ask spread and how it impacts your trading strategy. However, to do that, we first need to grasp what “bid” and “ask” mean in the stock market and how they create the price range known as the spread. Let’s start!

What does “bid-ask spread” mean?

In the world of buying and selling things like stocks, currencies, or commodities, three key terms you’ll often hear are “bid,” “ask,” and “bid-ask spread.”

The bid is the highest price that a buyer is willing to pay for an item. If you’re looking to sell a stock, for example, this is the most money someone is offering to buy it from you.

The ask is the lowest price at which a seller is willing to sell an item. If you’re looking to buy a stock, this is the lowest price you’ll need to pay to get it.

The bid-ask spread is the difference between the bid and the ask prices. It’s like a gap. If the bid price is £100 and the ask price is £102, then the bid-ask spread is £2. The spread is important because it’s a cost that traders have to consider. A smaller spread often means it’s easier and cheaper to buy or sell, while a larger spread might mean the opposite.

Bid-ask spread and market depth

Market depth is closely related to bid and ask prices. It gives you a broader picture of how much interest there is in buying or selling a particular item like a stock at various prices. In simple terms, market depth shows you how many shares of a company people are willing to buy or sell at different prices.

Imagine a list that shows you not just the highest bid price and the lowest ask price, but also other bid and ask prices along with the number of shares at each of those prices. This list gives you an idea of “depth,” showing how much demand (buyers) and supply (sellers) there are at different price levels.

Imagine you look at the trading platform and see the following information for ABC:

Bid Side (Buyers):

• £50 for 100 shares (which means that one buyer is willing to pay £50 for up to 100 shares)
• £49 for 200 shares (which means that another buyer is willing to pay £49 for up to 200 shares)
• £48 for 150 shares (which means that another buyer is willing to pay £48 for up to 150 shares)

Ask Side (Sellers):

• £52 for 50 shares (which means that one seller is willing to sell for £52 and has 50 shares available)
• £53 for 100 shares (which means that another seller wants £53 and has 100 shares to sell)
• £54 for 70 shares (which means that another seller is asking for £54 and has 70 shares)

In other words:

• The highest bid is £50 for 100 shares. This is the most any buyer is willing to pay right now.
• The lowest ask is £52 for 50 shares. This is the least any seller will accept right now.

The bid-ask spread here is £52 (ask) – £50 (bid) = £2.

There are multiple buyers and sellers at different prices, which suggests there’s a good amount of activity or “liquidity.” The market depth shows you that if you want to buy more than 50 shares, you’d have to pay at least £53 for the next set of shares. Similarly, if you want to sell more than 100 shares, you’d have to go down to £49 to find more buyers.

This example shows you not just the highest bid and lowest ask, which are the prices you’d get if you want to buy or sell right away, but also what options you have if you’re willing to wait for different prices. It gives you a deeper view of the market, hence the term “market depth.”

If no one is willing to sell at a certain price, investors will have to buy at higher prices and therefore the price will be higher. On the other hand, if there are no investors willing to buy at a certain price, sellers will have to put orders at lower prices, until they find buyers and therefore the price will be lower.

Spread formula

Based on this, the bid-ask spread formula is:

Spread = Ask Price – Bid Price

However, in percentage terms, which is how brokers usually list the spread they charge, the formula is:

Spread as a percentage = Bid-ask spread/ask price

How does liquidity impact the bid-ask spread?

Liquidity refers to how easily you can buy or sell something without causing a big change in its price. In the context of bid and ask prices, liquidity has a significant effect on the spread between these two prices.

When there is high liquidity, it means there are lots of buyers and sellers. In this situation:

1. Smaller spread: The gap between the bid and ask prices is usually smaller. This is because the high number of buyers and sellers makes it more likely that someone will accept a price close to what you’re offering.
2. Less price impact: Buying or selling large amounts won’t change the price too much because there are plenty of people willing to trade at close-to-current prices.

When there is low liquidity, meaning fewer buyers and sellers, the opposite happens:

1. Larger spread: With fewer people trading, the gap between the bid and ask prices tends to be larger. Sellers ask for more, and buyers offer less because they have fewer options to choose from.
2. More price impact: If you try to buy or sell a large amount, you might noticeably change the price because there aren’t enough people to take the other side of the trade at close-to-current prices.

So, in a market with high liquidity, you’re more likely to enjoy smaller bid-ask spreads and less impact on price from your trades. In a market with low liquidity, expect wider bid-ask spreads and more significant price changes when you trade.

What is the relationship between spread and volatility?

Volatility refers to how much the price of something like a stock or currency is moving up and down. If the price jumps around a lot, we say it’s “highly volatile.”

When prices are moving a lot (high volatility), the spread often gets wider. This happens because sellers and buyers become more cautious. Sellers ask for higher prices, and buyers offer lower prices because both are unsure where the price will go next.

When prices are stable (low volatility), the spread is often narrower. This is because traders feel more confident about where the price is headed, so they are willing to buy and sell at prices that are closer together.

If volatility is very high, your profitability could be reduced, since the spread would also be high.

Zero-commission brokers: what does it mean?

Zero-commission brokers offer free trades, but they have other ways to make money. Even though they don’t charge you a commission for buying or selling, they might make money on the bid-ask spread. They might offer you a slightly higher price when you’re buying and a slightly lower price when you’re selling compared to the actual market prices. The difference is small but adds up with a lot of trades.

In a regular market, you might see a stock with a bid price of £50 and an ask price of £52. The spread here is £2. Now, a zero-commission broker might quote you a slightly different bid and ask. For example, £49.98 for bid and £52.02 for ask. The broker has added a small margin to both sides of the trade. This is sometimes called the “markup.”

If you want to buy the stock, you’d pay the higher ask price of £52.02 instead of the market ask price of £52. The 2 extra pence per share go to the broker. If you’re selling, you’d get the lower bid price of £49.98 instead of the market bid price of £50. Again, the broker keeps the 2-pence difference per share.

While you’re not paying a direct commission, you are effectively paying a cost through this spread markup. This is why it’s always good to be aware of the spread and how it impacts the cost of your trades, even in a zero-commission setting.

In summary, zero-commission brokers might make their money on the spread by slightly adjusting the bid and ask prices. It’s a way for them to offer “commission-free” trading while still generating revenue.

The spread between the bid and ask prices is not fixed and can change for various reasons. Market conditions like how many people are buying or selling (liquidity) and how much prices are moving (volatility) can affect the spread. The time of day and the popularity of the asset being traded can also impact it. Some brokers might offer fixed spreads, but most spreads are variable and can widen or narrow based on these and other factors. So, while the spread might be a certain amount at one moment, it can change quickly.

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Bid-ask spread: summary

Certainly, understanding the bid-ask spread is crucial for traders because it directly impacts the cost of entering and exiting a trade. The spread can vary based on several factors like liquidity and volatility, making it a dynamic aspect of trading that requires continuous attention.

Even in zero-commission trading platforms, costs aren’t entirely eliminated but are instead incorporated into the spread. So, for traders, being aware of the bid-ask spread is not just about understanding market mechanics; it’s also about managing costs effectively to improve overall trading performance.

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