What is a Bid-Ask Spread?

The stock market in India has witnessed a record number of new investors in the past year. It’s crucial to develop a solid understanding of the bid-ask spread.

In this blog, we will explore the concept of bid-ask spread, the factors that influence it and its significance. 

What is Bid and Ask?

Bid and ask can be defined as:

• Bid Price: The bid price is the price a buyer is willing to pay for a security. It’s the amount a seller can receive if they sell their security at that moment.
• Ask Price: The asking price, also known as the offer price, is the price at which a seller is willing to sell a security. It’s the amount a buyer must pay to buy the security.

What is Bid-Ask Spread?

The difference between the bid and ask prices is known as the “Bid-Ask Spread.” This spread indicates the liquidity and volatility of security. A narrow spread typically suggests a highly liquid market with low volatility, while wider spreads indicate lower liquidity with higher volatility.

Calculation of Bid-Ask Spread

The bid-ask spread can be calculated using the following formula:

Bid-Ask Spread = Lowest Ask Price – Highest Bid Price

Example: Suppose a stock is trading with low liquidity and is currently trading at INR 107. A trader wishes to purchase a stock and sees the following information:

Lowest Ask Price = INR 110

Highest Bid Price = INR 105

In order to purchase the stock immediately, the trader must pay the ask price, which is the price a seller is willing to accept to sell the security. Bid-Ask spread, in this case, is INR 5. Now, let’s see what narrow and wide bid-ask spreads signify.

Narrow Bid-Ask Spread

In a narrow bid-ask spread, the gap be­tween bid and ask prices is tiny. It’s ge­nerally a sign of high liquidity, a condition where lots of pote­ntial buyers and sellers are­ present. This makes trading the­ stock simpler and doesn’t drastically swing its price.

Wide Bid-Ask Spread

In a wide bid-ask spread, the bid and ask price­s are far apart. That’s a sign of low liquidity. Selling or buying a stock can be a tough task without causing a lot of change in the­ price. The execution cost per share increases, and you may have to pay more for purchasing a share or accept a lower price when selling a share. 

Significance of Bid-Ask Spread

The bid-ask spread can be used in the following ways:

• Liquidity Indicator: A narrow bid-ask spread indicates high liquidity, while a wide bid-ask spread indicates lower liquidity.
• Transaction costs: A wide bid-ask spread indicates that the transaction costs would be higher. On the other hand, a narrow bid-ask spread indicates lower transaction costs.
• Volatility Indicator: A wide bid-ask spread means the participants in the market are cautious of high volatility. Meanwhile, markets with a narrow bid-ask spread indicate low volatility.
• Market efficiency: In efficient markets, the market information flows freely, and due to the low probability of volatile movements, the bid-ask spreads are generally narrow. On the other hand, inefficient markets often have a wide bid-ask spread.

Factors that Influence BID-ASK Spread

Various factors that affect the bid-ask spread are given below:

• Liquidity: Highly liquid stocks, such as those of large, well-known companies, generally have narrower spreads because there are many buyers and sellers. Whereas less liquid stocks often have wider spreads due to fewer market participants.
• Market Conditions: During periods of high volatility or market uncertainty, spreads can widen as market participants become less willing to transact at the current prices.
• Stock Price: Higher-priced stocks have larger absolute spreads, although the percentage spread may remain small. Lower-priced stocks can have relatively smaller absolute spreads.
• Trading Volume: Stocks with higher trading volumes have narrower spreads due to the high competition among buyers and sellers.
• Time of Day: Usually, spreads are wider at the market open and close due to increased volatility and lower liquidity during these times.

Read Also: What is Spread Trading?

Conclusion

The gap be­tween bid and ask is key to trade­ execution. A trader should trade in markets with a narrow bid-ask spread as a wider bid-ask spread increases the transaction costs and, thus, reduces the profit of the trader. However, it is advised to consult a financial advisor before making any investment decision.

Frequently Answered Questions (FAQs)