What is a Bid Ask Spread and How does it work?

What is a Bid Ask Spread and How does it work?

A lottery is not what happens on the stock market. However, the stock market is used by people, businesses, and governments as an auction to purchase and sell shares. To understand the different purchasing and selling possibilities, it is essential to understand bid-ask spreads. 

A bid ask spread means the difference between the highest price buyers are prepared to pay and the lowest price sellers are willing to accept for an item. Online share trading requires a thorough understanding of the bid-ask spread because it enables traders to evaluate the cost and liquidity of trading a certain stock. 

Explaining the Bid Ask Spread

When a trader enters the market to place a transaction, they must have a fundamental understanding of the bid-ask spread. When there is an imbalance between the supply and demand of the assets, the market primarily recognises a spread.

Due to this difficulty in obtaining assets, their values fluctuate, affecting the spread—the gap between the ask and bid prices.

Assets or securities are offered by brokers or market makers with two price tags. They list both the asking price (also known as the ask price) and the bid price (also known as the cost price) for the same item. Investors weigh their options by comparing prices before deciding whether to purchase or sell stocks. They select one of the two options depending on their view of potential profit. 

No matter whatever possibilities for the bid-ask spread they select, the market makers who propose the transaction would earn from the difference between the ask and bid prices. 

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Table of Content

  1. Explaining the Bid Ask Spread
  2. Relationship between Liquidity and the Bid-Ask Spread
  3. Elements Affecting Bid Ask Spread
  4. Formula of Bid Ask Spread
  5. How to Make Money from the Bid Ask Spread
  6. Conclusion

Relationship between Liquidity and the Bid-Ask Spread

Since each asset has a different level of liquidity, the amount of the bid-ask spread varies from one asset to another. The bid ask spread is the commonly used tool for evaluating market liquidity. Because certain markets are more liquid than others, their spreads should be smaller. In essence, counterparties (market makers) provide the liquidity that transaction initiators (price takers) seek.

One of the most liquid assets in the world is money, and the bid-ask spread in the currency market is one of the lowest (one-tenth of a percent); in other words, the spread is measured in fractions of a penny. Conversely, spreads on less liquid assets, including small-cap equities, might be as high as 1% to 2% of the asset's lowest ask price.

The market maker's estimated risk in presenting a transaction can also be reflected in bid-ask spreads. For instance, the bid-ask spreads on options or futures contracts could be substantially higher than those on currency or stock trades. Liquidity and the potential speed of price changes might both influence the spread's breadth.

Elements Affecting Bid Ask Spread

When traders compute the bid-ask spread, they get data for one share of the underlying asset. As a result, the trading volume, or the number of traded stocks, is crucial since it has a significant impact on the outcomes. 

Spreads on the lightly traded equities are greater. Given how volatile the stocks are, the spread's width is not constant and varies from security to security. In a market with greater liquidity and better trading volume, the spread is low because there are more traders overall—both buyers and sellers.

Market volatility is another aspect that has a significant impact on the bid-ask spread. The spread grows as the market experiences frequent volatility.

Formula of Bid Ask Spread

The necessary calculations are performed using the bid-ask spread formula shown below:

Spread = Ask Price - Bid Price

Let's look at a real-world bid-ask spread example to see how it functions

Ram chooses to use his resources to purchase a few stocks. He considers buying ABC stock. As a result, he makes contact with his longtime investment buddy Shyam, who requests that the former ascertain the spread for the firm beforehand.

The investor is aware that knowing the bid-ask spread can be useful for Ram in the future.

As a result, Shyam offers the following information:

  • The expected bid price for an ABC stock is Rs.100.
  • A share of ABC is being asked for, or considered to be, Rs.102 per share.

Ram is a novice investor, hence he is unable to comprehend the spread. He discovers the formula and uses it as a result. He also determines the spread of the ABC stock in one step. His calculation is as follows:

Spread is the difference between the stock's Ask and Bid prices.

= Rs.102 – Rs.100

= Rs 2

How to Make Money from the Bid Ask Spread

By following different sorts of orders, you may take advantage of the bid-ask spread. They are listed below:

The Market's Order

A market order is a trade instruction to buy or sell shares at the current market price. Specialists are able to ensure the execution of the order, but they are unable to guarantee the trade's execution price. A market order is executed in accordance with the bid-ask spread at (or very near) the standing bid-ask level.

The Limit’s Order

With a limit order, you can purchase and sell assets at a specific price or higher. You should be aware of the limit order variations as an investor. Buy limit orders, for instance, are often filled at or below the security's limit price.  

The Stop Order 

A stop order, sometimes referred to as a "stop-loss," is an instruction to buy or sell a stock once it hits a particular price level. This level is also known as a stop price; once the stop order hits it, a trade can be conducted. Usually, the stop order is carried out as a limit order. It is further divided into two categories: sell-stop orders and purchase-stop orders.

Conclusion

The demand-supply for an asset is what the bid-ask spread means. Although there are ways to eliminate the bid-ask spread, most investors are better off staying with this tried-and-true strategy, even though it does reduce their profit slightly. 

You might feel too inexperienced to use these sophisticated techniques. Thankfully, you may speak with a broker or brokerage company like blinkX to assist you in making the best investment choice.
 

What is a Bid Ask Spread? FAQs

Bid ask spread means the difference between the greatest price a buyer will pay for an asset (the bid price) and the lowest price a seller would take (the ask price). 

Market players' (buyers' and sellers') perceptions of an asset's worth differ, which is why the bid-ask spread arises. 

The market's supply and demand dynamics have a major role in determining the bid ask spread.

Since it is an instant cost of joining or quitting a position, the bid ask spread has a direct impact on traders and investors.

The bid ask spread is typically set by the market and cannot be negotiated directly.