What Is Bid-Ask Spread? Meaning & Importance | Groww

The bid-ask spread is a vital concept in trading securities. It is the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask) for any security/asset. This is thus a major transaction cost in trading, with narrower spreads often indicating higher liquidity and wider spreads indicating lower liquidity/higher volatility. 

Thus, you can call it the gap between the best bid price and the best ask/offer price. So, if any stock has a bid price of ₹99 and an ask price of ₹100, then the spread is ₹1. The bid-ask spread in this case serves as compensation for market makers, with a view to enabling liquidity and taking on risk.

A smaller spread automatically equates to lower trading costs, while a wider spread means higher costs (and often higher risks). Highly traded and liquid securities often have narrow spreads, while less-traded and illiquid assets have wider spreads. 

Meaning of Bid Price and Ask Price

The bid price is the highest price that a buyer is willing to pay for an asset. On the other hand, the ask price is the lowest price that a seller is willing to accept for the same. The difference between them is called the spread, representing transaction costs and overall market liquidity (with the ask usually higher than the bid).

The bid price is what you get when you’re selling a security, while the ask price is what you pay when you’re buying a security. Hence, the former denotes demand, while the latter denotes supply. 

A smaller spread indicates the asset is easier to trade and has high liquidity, while a wider spread indicates lower liquidity.  

Bid-Ask Spread Formula with Example

The bid-ask spread formula is the following: 

Absolute Spread = Ask Price - Bid Price 

Percentage Spread = Ask Price - Bid Price / Ask Price x 100 

Suppose you are buying a highly liquid stock that is trading on the NSE. In this case, let us assume that the highest bid price (buyer) is ₹2,500, while the lowest ask price is ₹2,501. In this case, the spread is ₹1 (₹2,501 - ₹2,500). 

The percentage spread is the following - 

(1/2501) x 100 = 0.0399%

Why a Spread Exists in Every Tradable Security

A spread exists in every tradable security, as it is the most fundamental mechanism for compensating market makers, ensuring liquidity, enabling instant trades, and managing risk. It indicates the difference between the buyer's bid and the seller's ask price, thereby serving as a transaction cost that reflects the asset's liquidity, market volatility, and compensation for potential price fluctuations.

Here are some of the reasons for the existence of the spread in every tradable security: 

• Facilitating Liquidity: Market makers enable trades by being ready to sell or buy. The presence of the spread ensures they can earn profits from offering this service rather than waiting for counterparties. 
• Compensation for Risks/Volatility: In highly volatile markets, the spread naturally widens to safeguard liquidity providers from rapid price fluctuations and higher-risk trades. 
• Information/Transaction Cost-Related Risks: The spread offers coverage for the costs of running trading infrastructure and for the risk of competing with traders who may have better data/information. 
• Inventory-Linked Risks: Market makers face risks when holding inventory (holding assets and waiting for price movements). Hence, they often widen spreads to offset holding risk. 

In this case, you should remember that popular and high-demand assets have tighter spreads/low costs due to higher activity. Conversely, less-traded assets have wider spreads. Also, spreads may widen during high-volatility market events (openings or closings) and narrow during peak activity hours. 

What Does a Narrow Spread Mean

A narrow spread indicates a tiny difference between the highest bid/buying prices and the lowest ask/selling price for any asset. It reflects higher market liquidity and trading volumes, along with lower transaction costs. The narrow spread reflects robust competition among market makers and a more efficient, stable market. Here are some of the major implications of narrow spreads: 

• Higher liquidity: An active market with high trading volume (popular stocks such as Amazon, Apple, Reliance Industries, etc.) enables quick, convenient buying and selling. 
• Lower transaction costs: Traders pay less to enter and exit their positions, thereby increasing potential profits. 
• Stability in the market: Investor confidence and lower volatility often lead to tighter bid-ask spreads. 
• Efficiency in the market: This often indicates more efficient price discovery, as evidenced by widely traded, highly competitive financial instruments. 

What Does a Wide Spread Mean

A wide spread from a market-oriented perspective means the difference between the highest bid/buyer price and the lowest ask/seller price for any asset/security. It usually signals lower liquidity, higher volatility, and greater risk. Thus, it is more costly to swiftly enter or exit positions while trading. Here are some of the major implications of wider spreads: 

• Higher transaction costs for traders: This happens due to the wider gap. 
• Lower liquidity levels: Wide spreads happen when there are fewer sellers and buyers, thereby making it tougher to fill orders at fair prices. 
• Risks and volatility: Spreads are often widened by market makers during periods of market volatility or instability. This is done to safeguard them against uncertainty and sudden price fluctuations. 
• Market indicators: Obscure, small-cap, or thinly traded stocks often have wider spreads than blue-chip stocks or those that are popular and heavily traded. 

A wider spread thus lowers potential profits, since traders have to gain more from price movements just to break even. 

Factors Affecting Spread: Liquidity, Volatility, Stock Price, Time of Day

Here are some of the factors that influence whether the spread is narrow or wide. 

Trading Volume/Liquidity: The main driver of the spread width is liquidity. In a scenario where stocks have high trading volumes, they usually have narrower spreads. This is because several participants are buying and selling, thereby increasing competition among market makers to offer the best prices. Alternatively, thinly traded or small-cap stocks often have wider spreads due to fewer buyers and sellers and lower liquidity. In such scenarios, market makers need more compensation for the risk of holding the asset. 

Volatility Levels: Volatility measures the magnitude and speed of price fluctuations. When volatility is high, i.e., prices move swiftly, risk and uncertainty also increase. Market makers widen the spread to safeguard themselves against potentially buying high and selling low immediately after. In a low-volatility situation, i.e., when the market is more predictable or stable, markets usually have narrower spreads since there is lower risk of sharp price movements against the market maker. 

Stock Price: The nominal stock price directly affects the spread in percentage terms. Lower-priced stocks often have higher relative spreads. Higher-priced stocks usually have smaller spreads relative to their values. 

Time of the Day: Spreads may vary, depending on the timing of the trading activity in the market. Spreads are usually widest at market open and near the close. High volumes and uncertainty occur during these times, while volatility risks lead market makers to widen their spreads. During midday, spreads often narrow with market activity stabilising. Spreads are also much wider during extended trading hours (after-hours/pre-market) owing to considerably lower liquidity. 

How Spread Affects Your Actual Buying and Selling Price

The spread acts as an embedded transaction cost that immediately affects the profitability of trades. Whenever you buy an asset, you’ll pay the high ask price, and when you sell, you’ll get the lower bid price. Here’s how it impacts the actual buying and selling prices: 

• Higher Cost of Entry: You should buy at the ask price, which is always slightly higher than the market price (the midpoint between the bid and the ask). 
• Lower Exit Revenues: You will sell at the bid price, which is always slightly lower than the market price. 
• Instant Negative Returns: Since you’ll be buying high and selling low, you will begin the trade with an immediate loss (equivalent to the spread amount). 
• Higher Break-Even Point: The price of the asset should increase by at least the spread amount in order for you to just break even on the deal. 
• Tighter Spreads and Lower Costs: Alternatively, a narrow spread (common for high-volume markets and highly liquid stocks) will lower your transaction costs, thereby enabling you to potentially profit earlier. 

Bid-Ask Spread vs Slippage

Both the bid-ask spread and slippage are hidden trading expenses that affect the final execution price of any asset. However, they arise from varying mechanisms. The bid-ask spread is the structural, visible difference between the highest price the buyer will pay and the lowest price the seller will accept. On the other hand, slippage is the unpredictable gap between the expected and actual execution price, typically seen in low-liquidity or fast-moving markets. 

Here is a round-up of their differences: 

As mentioned, you can view the spread in the order book before placing the order. However, slippage occurs when a market order is filled at a price different from the requested one, mostly because the price moved before the order was processed.

It is quite likely in fast-moving markets or even when large orders are filled in thin markets (when sufficient volume is not available at the best price). Negative slippage means a worse price, while positive slippage means a better price. Thus, note that low liquidity may enhance both the spread width and slippage potential. 

Large orders sometimes do what is called "walking the book," i.e., they use up all the liquidity available at the best ask/bid. This forces the trade to be filled at the worst price (slippage).

To bypass negative slippage, you should use limit orders that specify the maximum price you’re willing to pay. Also, make sure you trade during active hours, when liquidity is at its highest. Avoid large market orders in illiquid markets as well to reduce their impact on prices. 

How Traders Reduce Spread Costs

Traders follow various strategies to reduce their spread costs. Some of them include: 

• Trading during peak market hours (when liquidity is the highest): The spreads are the narrowest when the highest volume of sellers and buyers is active in the market. You should avoid off-hours and low-volume periods, such as lunch hours or the opening minutes. Many traders feel that the best time to trade in Forex is when the New York and London sessions overlap, for instance (12:00-17:00 GMT). 
• Selecting liquid assets: Those with high trading volumes, such as blue-chip stocks, naturally have tighter spreads (because competition among market makers is higher). You can avoid thinly traded assets, which often have wide spreads, making them costlier to trade. 
• Using limit orders in place of market orders: Note that market orders execute instantly at the best available prices, which often means that you’ll have to pay the highest spread. However, by placing a limit order, you’ll set a particular price, thereby avoiding the cost of crossing the whole spread. 
• Choose the right account type and broker: Compare spread markups across multiple brokers beforehand. ECN (Electronic Communication Network) or raw spread accounts may offer direct access to the market prices (sometimes going as low as 0.0 pips). However, they may charge flat commissions, which are sometimes cheaper than spread-only accounts. High-volume traders may consider looking at these aspects carefully. Also, choose a broker with transparent, competitive pricing and no hidden fees. 
• Do not trade during major news events: Any key news release (interest rate announcements, economic movements, etc.) may increase market uncertainty and lead to subsequent volatility. This may lead to widening spreads across market makers as a form of protection. Always track economic calendars and avoid entering trades just before/during big-ticket announcements. 
• Using low-spread/scalping strategies: This involves executing multiple fast trades to earn small profits, making tight spreads crucial for success (less than 1 pip). 

These strategies can help traders reduce spread costs and earn higher profits on transactions.