September 28, 2020
In trading stocks, bonds, commodities or other financial assets, we often encounter a bid-ask spread on prices, but what does this mean? How can it impact your trading as a buyer or seller? In its most basic form, the bid-ask spread is simply the highest price offered to purchase an asset (the bid) and the lowest price at which an asset can be purchased (the ask).
For example, suppose I was a market maker on a particular stock, let’s call it “ABC” and for my order book, I may have some customers that are willing to pay $10 for 100 shares, others willing to pay $10.25 for 200 shares and others willing to pay $10.32 for 500 shares. I may also have customers willing to sell their stock at $10.50, $10.65 and $10.80 , each for 200 shares respectively. So, my order book might look like the following:
In this case, the bid-ask spread would be $10.32 - $10.50, 500x200, indicating that the best bid is $10.32 and the lowest offer is $10.50, for 500 and 200 shares respectively. If you wanted to sell 500 shares at the market (i.e. you want to “hit the bid”) then you would sell your shares at $10.32. If you wanted to buy 500 shares at the market, you would pay an average price of $10.62 (200 shares at $10.50, 200 shares at $10.65 and 100 shares at $10.80). In some cases, a market maker may step in and take the other side of your trade, as long as they are bidding more than the highest bid, or offering at below the lowest ask.
When we combine all the order books for each market maker in a stock, we arrive at the market bid-ask spread, which often results in the bid-ask spread being a penny or less (in the example above, we might see a market bid-ask spread of $10.40-$10.41, which would make market orders more attractive).
Paying close attention to the bid-ask spread pays off on thinly traded instruments, where the spread may be wider (similar to the order book example above). This may include stocks, but can often include options where trading volume and open interest are lower. For example, you may see a market spread on a February 2021 call option with a strike price of $12 for ABC that trades at a bid-ask spread of $0.75 - $1.00. In this case, the spread amounts to between 25% and 33% of the value of the option, depending on whether you are buying or selling. In these cases, it might be more prudent to place a limit order, say to buy one call at a price of $0.85, rather than just taking the offered $1.00 price, saving you $0.15, which can add up quickly and significantly impact your overall returns.
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