What do you mean by Bid-Ask Spread?
The portion by which the asking price for an asset in the market surpasses the bid price is known as the bid-ask spread. The difference between the highest price a buyer is prepared to spend and the lowest price a seller is prepared to accept for a commodity. So, a person seeking to sell will be paid the bid price, while a person wanting to purchase will pay the asking price.
Let’s try to understand Bid-Ask Spread
A security’s price represents the market’s assessment of its worth at any given time, and it is unique. If you want to delve in deeper about why there is a “bid” and a “ask,” consider the two main actors in each market transaction:
1. the price taker (trader)
2. the market maker (counterparty)
Brokerages mostly hire market makers; their work is to sell assets at a set price, the asking price, and bid to buy assets at a set price, which is the bid price. At the beginning of the deal, the investor needs to accept one of these two prices based on whether they want to purchase the security (ask price) or sell (bid price). The spread is the primary transaction cost of trading (apart from fees). Thus it is recovered by the market maker via the natural flow of order processing at the bid and ask prices. The above mentioned is what the financial brokerages believe in when they say their profits come from traders or “crossing the spread.”
The “bids” and “asks” can have a large influence on the bid-ask spread. The spread tends to widen substantially if fewer players limit orders to purchase an asset (resulting in lower bid prices) or fewer sellers issue restrictions on orders to sell. As a result, while setting a purchase limit order, it’s important to keep the bid-ask spread in mind to guarantee it executes correctly.
These market makers and other experienced traders capable of perceiving the approaching risk in the marketplaces too are capable of increasing the spread between their best bid and best ask at any given time. If all market makers start doing this on a particular asset, the quoted bid-ask spread will be wider than it is usually. There are various high-frequency traders and market makers who always try to profit from fluctuations in the bid-ask spread.
Relation of the spread to liquidity
There is frequent change in the magnitude of the bid-ask spread from one asset to the next according to the liquidity of each asset. The bid-ask spread is often used as a proxy for market liquidity. Many markets differ in liquidity; that is, some more liquid than others and their low spread can reflect this. The ones initiating the transaction (price takers) require liquidity, whereas counterparties (market makers) supply liquidity.
If taken as an example, Currency is arguably the most liquid asset available across the world, with one of the lowest bid-ask spreads (one-hundredth of a percent); the difference may be calculated in fractions of cents. Spreads for less liquid assets, such as small-cap equities, maybe comparable to 1 to 2 percent of the lowest ask price of the asset.
These spreads are capable of indicating a market maker’s estimated risk in making a deal. Options or futures contracts, for example, might have bid-ask spreads that are a significantly higher percentage of its price than a foreign exchange or stocks deal. The size of the spread can be determined not just by liquidity but also by how quickly the price can change.
Example of Bid-Ask Spread
Let’s assume the bid price for some random stock to be $19 while the asking price is $20, the bid-ask spread for the stock in question is $1. The spread may also be expressed as a percentage; it is often determined as a percentage of the lowest sale or asks the price. The bid-ask spread in terms of percentage for the stock in the preceding example would be measured as $1 divided by $20 (the bid-ask spread divided by the lowest ask price). This would yield a bid-ask spread of 5%. If there is a situation where a possible buyer agrees to buy the stock at a higher cost, or a possible seller volunteered to sell the shares at a cheaper price, this spread will close immediately in such a case.
Various elements in a Bid-Ask spread
An extremely liquid market for whatever security is one of the important aspects of the bid-ask spread to provide an optimum exit point to make a profit. Furthermore, to establish a spread, there needs to be a certain kind of friction between supply and demand for that security. Therefore, traders should typically utilize a limit order instead of a market order, which implies that perhaps the investor should choose the entry point initially so that they do not lose out on the spread opportunity. Since two deals are taking place simultaneously, the bid-ask spread involves a cost in all this. In the end, bid-ask spread transactions can take place in almost any type of security, with foreign Currency and commodities being the most common and popular options available.