The difference between the bid (sell) and ask (buy) prices of any instrument is known as the spread. That’s the short and simple explanation; as with anything in finance, though, things get a little more complex as soon as you start to dig down.
Brokerages and other traders need to make money somehow. Selling stuff for a little more than they buy it is one way of doing so, and this is partly the origin of the bid-ask spread. One implication of this applies especially to day traders: when the spread of a financial instrument is tight, meaning that there is only a small difference between the asking and selling price, that asset is cheaper to trade in the short term. (Buying and selling rapidly doesn’t mean sacrificing too much profit to what are, in effect, transaction fees.) In contrast, if the prices are further apart, i.e. the spread is wide, the instrument will cost more to trade.
What determines the spread on any given asset?
Market liquidity has a significant effect on how wide the spread is. During times of high liquidity, an instrument’s spread is typically low. When trading volumes are high and there are plenty of willing buyers and sellers, we’re looking at something close to a perfect market. As a consequence, the market price of the asset is accurately determined through people voting with their capital.
From the perspective of the brokerage or online trading platform that actually places retail investors’ trades, there is no need for transaction costs to be high, as any trade will easily be matched by another. On the other hand, if liquidity is low, spreads will often widen significantly due to the difficulty in pairing sellers and buyers.
The second major factor that influences spreads is volatility. This is easy to understand: when prices are fluctuating wildly, both buyers and holders of an asset face increased risk. Under these conditions, it makes sense to buy only when prices are relatively low and sell when they’re somewhat higher.
Bid-ask spreads can also be onerous if you are dealing in thinly traded securities. When there are relatively few offers to either buy or sell an asset, you can naturally expect larger gaps in price levels. The bid-ask-spread in such a scenario compensates the market maker if buyers cannot be found for the shares and prices changed before these buyers are found. (Market makers are large firms that set bids to both buy and sell a stock.)
Something else to consider, at least in certain markets, is information asymmetry. Remember that perfect market we just talked about? It’s a theoretical construct. In practice, some players in the market are always going to have better or more timely knowledge than others. Spreads therefore tend to widen at times like just before companies’ earnings announcements or during periods of political turmoil.
Examples of bid-ask spreads
In terms of how a retail forex investor may encounter a bid-ask spread, let’s say the current bid price for a currency pair such as the EUR/USD is 1.6835 and the current offer price is 1.6838. This simply means you can buy at 1.6838 and sell at 1.6835. The spread between the asking price (the lowest price at which someone will sell) and the bid price (the highest price at which someone will buy) in this case is 3 “pips”.
A highly liquid instrument in the stock or forex markets, like the EUR/GBP currency pair, often has very low spreads of less than one pip. (In forex, a pip is the smallest increment in which a currency pair can move and is usually the fourth decimal place in the price of the pair, though in pairs featuring the Japanese JPY and some other currencies, it is the second decimal place.)
For example, the spread on EUR/GBP could be 0.8 pips, meaning the buy price for the currency may be 0.87887 while the sell price is 0.87879. This pair costs very little to trade, so British pounds and American dollars are popular among scalpers. As the price can easily move by more than 0.8 pips (in our example) over a short period of time, it is possible to make a profit by trading these at high frequency
For comparison, let’s take an “exotic” currency pair that is characterised by low liquidity, like the GBP/ZAR. These often have a significantly wider spread and the current market price can change more rapidly. As the trading volume on the South African rand (ZAR) is generally very low, matching buy and sell orders on today’s market is not always guaranteed. In other words, the buy price could be 18.01400 while the sell price is 17.99300, resulting in a spread of 210 pips. Exotic currency pairs are therefore more expensive to trade in the short term.
We’ve mostly been talking about the forex market, so let’s consider stockes. If you are thinking of making a share purchase, you have to be confident that the stock’s price will advance far enough to overcome any obstacles to profit, including transaction fees and the bid-ask spread. Bid-ask spreads are especially high when it comes to relatively unknown, rarely-traded securities such as small-cap stocks. The spread can also vary from day to day, so it will probably be different when you decide to sell. Significantly, mutual fund buyers and sellers are not affected by bid-ask spreads, as the fund is priced once daily and buyers and sellers all see the same price.
In conclusion
One takeaway from this article is that the spread can sink your hopes of profit if ignored. The significant effect that liquidity and volatility have on trading costs is one of the main reasons why beginners entering the market for the first time should mostly stick to trading the most liquid instruments.
As always, having and following a strategy is crucial. If, for example, you choose to get in and out of each position as soon as possible, you can place a market order and take the stock prices offered by the market, even though this places you at the mercy of the spread. Limit orders, which specify a maximum price to buy or minimum price to sell, are safer in this regard: if there are no offers that meet your requirement, your trade will simply not go through.
