Introduction
A bid-ask spread refers to 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 will 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 Bid-Ask Spread
A share price is the understanding of the market's value at any given point in time and is special. To understand the reason why there is a "bid" and an "ask," in every market deal, one must have 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 that it is successfully executed.
Relation to Liquidity
The size of the bid-ask spread will differ from one asset to another, 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. On 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.
