Bid-Ask Spread

Reviewed by Anjaneyulu | Updated on Aug 27, 2020

Introduction

A bid-ask spread is an amount by which the bid price for an asset on the market exceeds the bid price. The bid-ask spread is the difference between a buyer's willing to pay the highest price for an item and the lowest price a seller is willing to accept. A person who wants to sell will receive the price of the bid while one who wants to buy will pay the price of the offer.

Understanding

A share price is the understanding of the market 's value at any given time point and is special. To understand the reason why there is a "bid" and an "ask," in every market deal, one must have a factor in the two main players, namely the price taker (trader) and the market maker (the counterparty).

The bid-ask spread can be used as a measure of the supply and demand for a given commodity. Since the bid can be said to represent demand and the offer to represent the supply for a commodity, it can be possible that the market action represents a shift in supply and demand as these two prices grow further apart.

The depth of the "offers" and the "asks" can have a major impact on the bid-ask spread. The spread can widen considerably if fewer participants place limit orders to purchase a security (thus generating lower bid prices) or if fewer sellers place limit orders to sell. As such, having the bid-ask spread in mind when placing a buy limit order is crucial to ensuring it is successfully executed.

Relation to Liquidity

The size of the bid-ask spread from one asset to another will differs mainly because of each asset's differing liquidity. The distribution of the bid-ask is the de facto indicator of market liquidity. Specific markets are more liquid than others, and their lower spreads should reflect that. Transaction initiators (price-takers) basically claim liquidity, whereas counterparties (market-makers) have liquidity.

For example, the currency is known to be the world's most liquid commodity, and the bid-ask spread on the currency market is one of the smallest (one-hundredth of a %); that is, the spread can be calculated in fractions of pennies. At the other hand, less liquid assets, such as small-cap stocks, can have spreads equal to 1 to 2 % of the lowest offer price of the asset.