Understanding Bid-Ask Spread — What Every Investor Needs to Know

In this article, we will explore the topic in detail, examining its purpose, importance and how to calculate it.

Updated: May 18, 2024
Matt Crabtree

Written By

Matt Crabtree

CompareBanks is reader-supported. When you click through some links on our site, we may earn an affiliate commission. Learn more

Are you looking to invest in stocks and curious to understand bid-ask spread? You've come to the right place. The bid-ask spread is a crucial concept to understand when investing in the stock market.

In this article, we will explore the topic in detail, examining its purpose, importance and how to calculate it. Knowing what the bid-ask spread represents can help investors maximize their gains and protect their investments, so let's get started!

The Basics Of Bid-Ask Spread

What Is Bid-Ask Spread & How Does It Work?

The bid-ask spread is a term used by investors and traders to describe the difference in value between the asking price and bid price of a specific stock or security. The bid price is the most a buyer is willing to pay, making the ask price the lowest a seller will accept for the same asset.

The size of the bid-ask spread can vary based on a range of factors like the type of security being traded, the liquidity of the security, the amount of available buyers and sellers, and the market conditions. Generally, the more liquid a security is, the smaller the spread will be.

In addition to the bid-ask spread, investors can also use the bid-ask price to determine the going rate of the security. The difference between the bid and the ask price, often referred to as the midpoint, can be used as a guide to gauge the value of the security.

Understanding the concept of the bid-ask spread and how it works is essential for any investor or trader.

By recognizing the importance of this spread and how it can affect the buying and selling of a security, traders and investors can use it to their advantage by making informed decisions when buying and selling a security.

Why You Should Understand The Bid-Ask Spread

1. Make Informed Swapping Decisions 

The bid-ask spread affects the cost of buying and selling stocks, so it's essential to have a grasp on how the spread works and what it reveals about the stock market. By understanding the bid-ask spread, you can make informed trading decisions, as you will know when it is more profitable to buy or sell a stock.

2. Identify Liquidity

Additionally, you can also receive insights into the liquidity of a stock. For example, if the spread is large, it indicates low liquidity, as buyers and sellers may be further apart on the price. A narrow bid-ask spread indicates more liquidity and could mean that the stock can be easily bought and sold.

3. Calculate Regulatory Fees

So, what exactly is the benefit of the bid-ask spread in terms of regulatory fees? To put it simply, it is the difference between the cost of executing the trade and the transaction cost associated with executing the trade. 

By taking into consideration the bid-ask spread, a trader can calculate the regulatory fees of a particular security more accurately, as the bid-ask spread incorporates the costs of entering the market and the costs associated with executing it.

4. Gauge Market Sentiment

By understanding the bid-ask spread definition, you can gain insights into how traders and investors are feeling about a certain stock. For example, if the spread is widening, it could indicate there is a lot of uncertainty in the market and traders may be wary of buying or selling that stock.

How To Calculate The Bid-Ask Spread

As previously covered, the bid price is the highest price people are willing to pay for a security. This price is usually set by influential market makers or brokers. The ask price on the other hand is the lowest price sellers will accept for the same stock.

There are several ways to calculate the bid-ask spread formula:

Direct Calculation. The most straightforward way to calculate the bid-ask spread is to subtract the stock's bid price from the ask price. This will give you the amount that the seller is charging the buyer to complete the transaction.

This spread is an indicator of the current liquidity of the security and can help an investor determine the best time to buy or sell a particular stock.

For instance, say the bid price of a security is £50 and the ask price is £51, the bid-ask spread will then be equal to £1. Simple stuff.

Comparison with Other Securities. For instance, if the bid-ask spread of a security is 4%, you could compare it with the bid-ask spreads of other securities in the same market to see how it stacks up. This can provide helpful insight into the liquidity of a security and the amount of competition there is in the market.

Knowing how to calculate the bid-ask spread is essential for any investor or trader seeking to make more informed decisions and potentially increase their profits.

Exploring the Impact of the Bid-Ask Spread on Trading

How Does the Bid-Ask Spread Affect Investor Profitability?

When it comes to investing, a wide bid-ask spread can have a huge impact. For example, a widespread can eat into the profits of an investor making small trades, such as day trading. This is due to having to pay more to buy and sell assets and, as a result, their returns on investment can be reduced.

Large traders, however, may not be as heavily impacted by a wide bid-ask spread. They may be able to benefit from opportunities created by the spread, such as buying and selling large amounts of assets in a short period of time in a volatile market. 

It is also important to understand that the bid-ask spread is not static and can vary depending on market conditions.

When demand is very high and there are many buyers, the spread will generally be narrower. Similarly, when there is little demand and few buyers, the spread is typically wider.

Knowing how this can impact your trades is integral to successful investing. By taking the time to research the spread and how it relates to the market, you can make smarter investments and protect your portfolio from unnecessary losses.

Strategies For Optimizing Returns Despite The Bid-Ask Spread

The bid-ask spread can be a significant obstacle when it comes to making profits in the financial markets. Furthermore, the spread can make it difficult to optimize your returns, even when you are on the right side of the market.

Fortunately, there are strategies that can help you work around the drawbacks of the bid-ask spread:

Price Shop Around. The spread can vary significantly between different brokers, which means it's vital to shop around and compare the spreads offered by various platforms. This can help you to find the best broker for your trading strategy and optimize your returns.

Use Limit Orders. Another strategy for optimizing returns is to use limit orders rather than market orders. Limit orders allow you to specify the price at which your trade will be executed. This means you can set your order to be filled at the most optimal available price, which may be better than the current bid-ask spread.

Consider Non-Traditional Exchanges. These exchanges typically have a smaller pool of liquidity, so prices may be more volatile. However, if you are able to manage your risk, then these exchanges can be a great way to get the most out of your trade.

Take Advantage of Arbitrage Opportunities. Arbitrage is a popular trading strategy that takes advantage of price discrepancies in different markets. For example, when the same asset is being traded on two different exchanges, you may be able to buy at a lower price on one exchange and sell this at a markup on another platform. This can help you to maximize your returns despite the bid-ask spread.

Use Automated Trading Strategies. Finally, automated trading systems can scan the markets in real time and look for opportunities to buy and sell at advantageous prices. This can help you to take advantage of market fluctuations and ensure you aren't inversely affected.

Related Guides:

Related Articles

What Is a Visa Credit Card?
Are you looking for an extra cash boost but are not sure where to start? A Visa...
Should you Rent or Buy a Home?
Private rental prices have shot up over the last year but following several interest...
How Does Credit Scoring Work?
Your credit score is a record of how you manage your money and every time you apply...
Can You Transfer Money From Credit Card to Bank Account?
You may consider making a money transfer if you have a credit card and need cash...