Bid-Ask Spread

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What is a bid-ask spread?

A bid-ask spread is the excess of the bid price over the bid price of an asset on the market. The bid-ask spread is essentially the difference between the highest price that a buyer is willing to pay for an asset and the lowest price that a seller is willing to accept. An individual seeking to sell will receive the price offered while an individual seeking to buy will pay the asking price.

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Bid-Ask Spread

Understanding the gap between supply and demand

A stock price is the market’s perception of its value at a given time and is unique. To understand why there is a “offer” And one “request“you have to take into account the two main players in any market transaction, namely price taker (trader) and the market maker (counterparty).

The market maker, generally from financial brokerage companies, distributes (supply – price – demand) the price of the security to which the price taker deals. The difference is the transaction cost. The price takers buy at the seller price and sell at the seller price, but the market maker buys at the seller price and sells at the seller price. For the market maker, the low buying paradigm – high selling to make a profit is satisfied. This is what financial brokerages mean when they declare that their income comes from traders “crossing the gap”.

The bid-ask spread is a reflection of supply and demand for a particular asset. Supply represents demand and demand represents the supply of an asset. The depth of “supply” and “demand” can have a significant impact on the bid-ask spread, which widens it considerably if one wins out over the other or if the two are not robust. Market makers and traders make money by exploiting the bid-ask gap and the depth of the offers and demand to compensate for the spread gap.

Key points to remember

  • The bid-ask spread is essentially the difference between the highest price that a buyer is willing to pay for an asset and the lowest price that a seller is willing to accept.
  • The difference is the transaction cost. The price takers buy at the seller price and sell at the seller price, but the market maker buys at the seller price and sells at the seller price.
  • Supply represents demand and demand represents the supply of an asset.
  • The bid-ask spread is the de facto measure of market liquidity.

Relationship between bid-ask spread and liquidity

The size of the bid-ask spread from one asset to another differs mainly due to the difference in liquidity of each asset. The bid-ask spread is the de facto measure of market liquidity. Some markets are more liquid than others and this should be reflected in their lower spreads. Essentially, transaction initiators (price takers) demand liquidity while counterparties (market makers) provide liquidity.

For example, the currency is considered to be the most liquid asset in the world and the bid-ask spread in the currency market is one of the smallest (one hundredth of a percent); in other words, the spread can be measured in fractions of cents. On the other hand, less liquid assets, such as small-cap stocks, can have spreads equivalent to 1 to 2% of the asset’s lowest selling price.

Bid-ask spread example

If the bid price for a security is $ 19 and the asking price for the same security is $ 20, the bid-ask spread for the security in question is $ 1. The bid-ask difference can also be expressed as a percentage; it is generally calculated as a percentage of the lowest selling price or the asking price. For the action in the example above, the bid-ask spread in percentage terms would be calculated as $ 1 divided by $ 20 (the bid-ask spread divided by the lowest selling price) to give a bid-ask spread of 5% ($ 1 / $ 20 x 100). This gap would close if a potential buyer offered to buy the stock at a higher price or if a potential seller offered to sell the stock at a lower price.

Elements of the bid-ask spread

Some of the key elements of the bid-ask spread include a very liquid market for any security to provide an ideal exit point for profit. Second, there should be some friction in the supply and demand for this stock in order to create a spread. Traders should use a limit order rather than a market order; which means that the trader must decide the point of entry so as not to miss the opportunity to spread. There is a cost associated with the bid-ask spread, since two transactions are carried out simultaneously. Finally, bid-ask spread trades can be performed on most types of securities – the most popular being currencies and commodities.

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