How to Easily Understand Bid-Ask Spread : A Term Every Investor Should Know

Updated: Aug 10, 2021

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What is Bid-Ask Spread?


Let’s say you’re at a garage sale and you see a rare Pokemon card you want to buy. So you go up to the Mr. Garage Sale Guy and offer to buy the card off of him for 10$.


But Mr. Garage Sale Guy is smart, and he knows there’s a lot of hype around Pokemon cards right now so he says he won’t sell it for anything under 15$.


So, your buying offer is 10$, and his selling price is 15$...The difference between your two offers is… you guessed it, 5$


In the investing world, this difference of 5$ would be called “The Bid-Ask Spread.”


Definition

By definition, the bid-ask spread is the difference between the asking price and the offering price of an asset in the market.


  • The Ask is the value that the seller is willing to sell a security at.

  • The Bid is the value that the buyer is willing to buy a security at.


The larger the gap between the two, the greater the spread!


Why Is It Important to Understand Bid-Ask Spread?

Understanding the bid-ask spread is essential to getting the best price whether you’re the buyer or seller of an asset.


The size of a bid-ask spread is also usually a good indicator of how liquid a market is. What does that mean you ask? - The liquidity essentially means how fast you can exchange something for cash. A highly liquid market means that you can get in and out of your trades faster. Which is what you want because it means you have more opportunities to trade.


Remember, when trading stocks and funds, there is always a buyer and a seller. If a market has low liquidity, then you’ll generally have a harder time trying to sell or buy your asset because no one is on the other end buying or selling...


Okay, so now that you understand liquidity, let’s dive a little deeper...


Here are two simple rules you should remember about liquidity:


  1. If a market is highly liquid, then the spread will be smaller.

Highly Liquidity = Smaller Spread.


  1. In contrast, if the market for the security has low liquidity, then the spread will be larger because there are less options to enter the market.

Low liquidity = Larger Spread


So, now we know that if look at the bid-ask spread, we can tell how liquid a market is.


Example:

Note: Generally, if you are trading options or stocks in a highly liquid market, then the bid-ask spread won’t affect you as much.


Highly Liquid Stocks:

Let’s say you have a stock called XYZ and the bid is at $97.55 and the ask is at $97.60 for a spread of 5 cents.


Low Liquidity Stocks:

Let’s also consider a stock with low liquidity. Let’s call this stock ABC with a bid of $60 and an ask of $62 for a spread of $2.


If you’re trading with a high bid-ask spread, then you will have to remember that since its harder for you to find a trade, then this means the market maker or broker you use, will charge a commission for helping execute the trade. The market maker or broker usually takes the spread as a commission or fee for helping you execute the trade.


The more difficult the market maker has with executing your trade, the higher the bid-ask spread will be. You can also think of the bid-ask spread as a markup on your purchase or sale for helping execute your trade.




When is bid-ask spread relevant to me?


Limit Order:

Generally, using a limit order gives you more control when buying or selling a stock or fund. This is because a limit order allows you to sell or purchase a stock or fund at a specific price of your choosing. This can be helpful if you know what price you are willing to sell or buy at. Or even if you know what price you’re willing to not buy or sell at.


For example, let’s say you’re looking to buy a share of Apple (AAPL). You see that Apple is selling at $150 a share, and you think that its overvalued and will eventually go under $140. Then you can set a limit order to only purchase a share of AAPL if the price goes under $140.


If you’re setting a limit order, the bid-ask spread would come in handy when anticipating whether or not a limit order you placed will actually be executed. This is because you understand the liquidity of the market and therefore will have an idea of whether or not your order will have a buyer or seller on the other end.


Market Order:

Unlike the limit order, the market order only gives you the option to sell or buy at the current market value of a security.


If you submit a market sell order, then you’ll receive the lowest buying price. And if you submit a market sell order, then you’ll receive the highest selling price.


Market orders are usually only a good idea if you want to buy or sell something immediately.

Things to Remember about bid-ask spread

This may be one of those terms that takes a while to really understand because you need to see it in action.


Just remember that bid-ask spread reflects the liquidity of a market and can show you the best opportunity to sell or buy a security.


Generally, the size of the spread and the liquidity of a stock are determined by the supply and demand. If there are more sellers and buyers, then there will be more trades.


Taking time to understand bid-ask spread will make you a better investor because you’ll know how specific orders can be leveraged to get the best execution price for your trade.


Bid-ask spreads can be assessed in all types of securities. But generally, they are quite popular in commodities, options trading, and forex trading. If you are interested in learning more about options trading and learning a skill that can help you achieve financial success, feel free to check out our different plans where we teach you about investing.