What is the bid-ask spread? A key to success in financial markets

Conventionally, the bid price is the price at which you can sell your stock, and the ask price is the price you would buy the stock. However, it goes much deeper than the surface-level understanding. 

This article will deeply dive into "What is the bid-ask spread?" We'll examine the significance of wide and tight spreads and how liquidity impacts them. We'll also provide tips and insights into how to make the bid-ask spreads work for you and help to improve your trades. 

Overview of the bid-ask spread

Any market includes buyers and sellers. It applies to supermarkets, car dealerships, retail stores and e-commerce. 

In the stock market, the buyers place the prices they are willing to buy stock at on the bid or the left side of the quote. Sellers who want to sell their stock list their offer prices on the ask or the right side of the quote. Buyers will buy your stock when you sell at the bid, and sellers will sell you their stock when you buy on the ask. 

Regarding bid-ask spread meaning, the best bid and best ask quote whenever you look up a stock price and current bid and ask. The U.S. Securities and Exchange Commission (SEC) regulates them and termed the national best bid offer (NBBO). The best bid is the highest price buyers are willing to buy your stock, and the best ask is the lowest price sellers are willing to sell you their stock. 

Despite having multiple electronic order books and market makers, the best bid and ask to attain the "inside" status. The "inside bid" and "inside ask" are the same as the best bid and best ask. Market orders to buy will automatically be filled at the ask price vs. bid price on market orders to sell will automatically sell at the inside bid.

The bid-ask spread definition is the price difference between bid and ask price, which is appropriately called the spread. The current stock market has narrowed the spreads to a 1-cent minimum increment. 

This doesn't necessarily mean that all stocks have a penny spread. It's just the minimum. As stocks move higher, the liquidity gets thinner as wide spreads appear. The bid-ask spread provides much information about the stock's liquidity and volatility. All trades require the bid-ask spread to place and complete trader orders. 

Best ask price – Best bid price = Spread 

For a spread example, if XYZ has a best bid price of $37.05 and a best ask price of $37.10, then you can calculate the spread by subtracting the $37.05 bid from the $37.10 ask, which equals 5 cents. 

XYZ stock would have a 5-cent spread. That spread can change since prices are not static but dynamic throughout the day as trades get executed. 

Factors affecting bid-ask spreads 

The spread can fluctuate from minute to minute and change in milliseconds. Many factors impact the bid vs ask for stocks. Any jump in volatility triggered by a spike in volume from news or events can widen the spreads quickly as the buyers or sellers panic the market. 

Eventually, the spreads tighten back up once the volume reverts to normal. A wide spread is a sign of thinner relative liquidity. This results in more slippage for the trader or investors. 

For example, if there is a 50-cent spread for ZYX at $95.50 x $96, you would buy at $96. If you change your mind and decide to sell it immediately afterward, you will sell it for $95.50, losing 50 cents because of the spread. 

When you buy on the inside, ask and immediately start a trade with a deficit. The larger the deficit or spread, the more slippage becomes a factor. You start every trade with a loss, which can add up if you're an active trader. 

High volume, market volatility and small float can make spreads wider. Although not always together. A stock with very little volume and no volatility can also have wide spreads due to the lack of participants — it's prevalent in small-cap and penny stocks. The type of stocks can impact the spreads as well. Large-cap, blue chip and dividend stocks tend to have tighter spreads due to the liquidity and numerous participants on the bid offers.

Impact of bid-ask spreads on traders

The bid-ask determines the price you are buying and selling a stock for. The spread determines the slippage, which can eat into your profits and add to your losses. Whether you like it or not, it's an expense paid from your transaction. Spreads will reduce your profits and increase your losses. Short-sellers can short-borrowed stock on the bid. A spread investor will always ask, "What is bid-ask spread?"

The tightness of a spread also indicates liquidity. Wider spreads indicate less liquidity and usually lighter volume since traders may be intimidated by the slippage. The wider the spread, the more loss you incur immediately on the trade. Reduced liquidity can also lead to higher volatility.  

You can mitigate wide spreads by making fewer trades and playing more shares to minimize the slippage effect on the total amount of the purchase. It's best to trade during the highest volume periods of the day, usually the first and last 30 minutes of the trading day. 

Be aware that news events like earnings reports, conference calls and analyst upgrades can trigger volatility, causing spreads to widen. You can mitigate the effects of wide spreads by placing a limit order between the spread. It may take longer to execute your trade, but placing limit orders between the bid and ask helps narrow the spread. This can also cause more participants to bid for the shares, creating a more efficient market. 

High-frequency trading programs can split the spreads to the ten-thousandth of a penny and execute orders in milliseconds. This enables them to because the inside bid and inside ask to skim minuscule fractional profits that add up over thousands and thousands of trades. 

Pundits argue that high-frequency traders add more liquidity to the market by splitting spreads and creating more liquidity. However, the criticism is that they don't provide any additional liquidity because they tend to buy and sell in milliseconds, skimming extremely thin profits along the way without actually providing liquidity. If a trader buys and sells a stock in under one second, it's hardly considered adding liquidity. Instead, it can be considered front-running real orders where participants intend to hold the shares instead of flipping them. 

Bid-ask spread in different financial markets 

It is important to understand that different financial markets and instruments will impact their respective bid-ask spreads. Different assets and markets can have different spread dynamics. The futures markets, like the ES contracts, can have 0.25-point spreads or $12.50. The S&P 500 futures are the most heavily traded benchmark futures contract, which enables tighter spreads due to the massive liquidity.

Forex and currency spreads are calculated in pips. For most currency pairs, the smallest unit is equal to 0.0001 pip. This is common with the most heavily traded currency pairs. As the currency pairs and commodity type get more exotic, the spreads get wider, which means more slippage occurs.  

Bid-ask spread and market efficiency

Narrow spreads are a sign of a more efficient market. You should always ask what is the bid/ask spread. Narrow spreads imply the existence of more participants who are competing to get the inside bid and ask to execute trades. More competition makes for more efficient markets. 

This is apparent during the active periods of the market every trading day. When there are few participants in a stock, the spreads can get wider due to the lack of interest in the stock. Wider bid-ask spreads indicate the lack of demand and competition. This results in less efficiency and more slippages, which are the effects of a wide spread. 

Strategies for dealing with bid-ask spreads

Here are some strategies for dealing with what is the bid-ask spread. 

Limit orders 

Limit orders add liquidity by splitting the inside bid and ask spread. You can continue to cancel and reenter your bid or ask between the inside bid and ask.

You can also add liquidity patiently by placing buy orders to buy on the bid or sell on the inside ask. You can collect pass-through fees through electronic communication networks (ECNs), which tend to incentivize traders to add liquidity by placing limit orders between the inside bid and asks.

The pros of limit orders:

• They can limit losses by having the floor to sell shares above if the stop triggers.
• They help to quantify your downside on a stop loss.
• They improve risk management. 

The cons of limit orders:

• They can take longer to fill since the price must be within the limit price parameters.
• Order execution is not guaranteed since the price could fall below your limit order price, disqualifying it from execution until the price recovers.
• They can be more complex than market orders.

Market orders

Market orders are the fastest orders for stocks. These orders don't apply a filter and are executed automatically at the inside bid and ask. Market orders should be limited to stocks with thick liquidity and very tight spreads, usually a few pennies maximum. 

Market orders should not be placed on stocks with wide spreads as the order will fill at any price that is on the inside at the time. Numerous horror stories exist about traders placing market orders on stocks during heavy periods of volatility and fast markets.

The pros of market orders are:

• They execute extremely fast since there are no specific requirements for the execution price.
• Market orders are guaranteed to be executed.
• They are simple to place just by hitting the market sell button. 

The cons of market orders are:

• They can fill at any price, even extreme levels.
• They can have a lot of slippage. 
• They can entail higher risk in fast-moving and volatile markets and stocks.

Stop orders

Stop orders trigger when a stock trades at a specific price. Stop orders can be stop limit and stop market orders. Stop limit orders will place a limit price to execute the trade once the limit price is hit. For example, if you place a stop order to sell XYZ stock, if it falls to $24.50, you can add the limit to sell at $24. If the stock falls under $25, the platform will sell the stock down to $24. If it falls too fast under the $24 level, it will hold the order until it exceeds the $24 limit. 

The market stop order will send a market order to sell if the stock price hits $25. The market order will be filled as soon as possible at whatever the inside bid is. Theoretically, XYZ may panic due to news, collapsing from $25 to $23 before the market order triggers. Since it's a market order, it can fill down to $23.

Bid-ask spread examples 

Here is a scenario illustrating the role of bid-ask spread in trading. 

The above illustration shows a level 2 market depth screen for Bank of America Co. NYSE: BAC stock. The bid prices are on the left side, consisting of the market maker, price and size. The market maker is the participant bidding, willing to buy, indicated by a three- or four-letter symbol. The participant can be an exchange like the NYSE or an electronic limit book ECN like ARCA. The price represents the best price the participant is bidding, offering to buy BAC stock. The size represents the number of shares the participant is willing to buy, represented in hundreds. For example, The best bid on BAC is from NQPX at $29.99 for 23,500 shares. 

The ask prices stack on the right side with the same headings. The best ask is offered from NASD for $30 for 9,200 shares. This means NASD is offering to sell 9,200 shares of BAC at $30.00. Therefore, the inside bid and inside ask for BAC is quoted as $29.99 x $30. The spread is 1 cent since that's the difference between the ask and the bid price. 

If you wanted to buy 500 shares of BAC, you would place a market order to buy 500 shares of BAC, which would execute at $30. The $30 represents the best ask price indicated on the right side. If you change your mind and decide to sell your 500 BAC shares, you would place a market sell order to close your position. 

It would execute your sale at $29.99. The $29.99 is the best bid price indicated on the left side. Your net loss would only be 1 cent, a tight spread with no slippage. 

Bid-ask spread and algorithmic trading

Some trading platforms will allow you to place a peg order, automatically placing your trade orders at the mid-point between the current inside bid and ask. 

This is very convenient since you don't have to cancel manually and reenter new trades to stay in between spreads. Peg orders and other algorithmic trading functions depend on your trading platform and brokerage. Algorithmic trading can be convenient due to its automation, but it can be risky if you don't monitor the executions. There's always a chance of errors that can be costly, and brokers tend to leave the responsibility on the trader in any case of problems. 

Bid-ask spread vs. commission fees 

If you are trading with a zero-commission broker, then it's important to gauge the bid-ask spread and executions. Zero-commission brokers have order flow agreements. They may often include a wider spread to skim a little more profit. 

Direct access brokers enable more control with their trading platforms and order routing capabilities at a price. They charge a commission based on your volume. Electronic order books and ECNs like ARCA, INCA and ISLD offer pass-through rebates to provide liquidity. If you sell stock on the inside ask rather than the bid, you can receive a rebate for the trade, which applies to your commission. 

Seasoned traders can perform spread trading to collect rebates. However, if you take liquidity by selling on the bid, the ECN will charge you a pass-through fee that gets added on top of the brokerage commission. Knowing the pass-through fees and rebates with your broker is important before making trades.

Bid-ask spread and market makers

Market makers compete with each other, placing their bids and ask prices. They are the original arbitrageurs of spread. A market maker will place his bids and asks with the hopes of buying on the bid and selling at the ask or short on the ask and cover on the bid. 

The spread is the market maker's profit. Market making was much more lucrative in the 1990s when the stock market used fractional increments. The minimum spread was 1/16th or 6.25 cents, compared to 1 cent today. 

As the markets migrated to decimal quotes and penny increments, many market makers went out of business as the profit margins were too small. Market makers can make profits with order flow and high-frequency trading programs that use blinding millisecond speed to execute numerous trades in fractions of seconds.

Using level 2 market depth screens 

Active traders tend to use level 2 market depth screens. These data feeds cost extra but provide more information about the liquidity of a stock. Normal inside bid and ask quotes only show the surface-level top quote. If JPM is quoted at $166.17 x $166/18, that represents the best bid and ask.

There is much more underneath the surface. The best bid and ask (yellow), then the second best bid and ask (blue), then the third best bid and ask (green) and so forth. Level 2 displays the depth of the limit orders below the surface, as in how many participants are willing to buy at the bid and sell at the ask and for how many shares. This can provide insight into what liquidity lurks beneath the inside bid and ask. 

Algorithms and high-frequency trading programs are notorious for splashing hundreds of bids and asks throughout the day, giving the appearance of buying or selling pressure even without the trades being executed. This is why it's important to also have a time and sales window in conjunction with level 2 screens to verify there is real buying or selling pressure as indicated by the actual trades. Charts are also superior since they only plot actual trades.

The bottom line on the bid-ask spread

The bid-ask spread is the market's way of managing supply and demand. Although primarily used to assist in the orderly trading of options, bid-ask spreads are also used by market managers to facilitate trading for securities that have low volume.

A bid-ask spread to be successful requires both a buyer and a seller. Traders can help ensure their success with bid-ask spread by using limit orders that ensure they can walk away from a trade if it doesn't meet specific price targets. Traders profit when investors execute market orders for a security without regard to the bid-ask spread because they essentially confirm another trader's bid.