Understanding Bid Ask Spread

The bid-ask spread is the difference between the highest price a buyer is willing to pay for an asset (the bid price) and the lowest price a seller is willing to accept (the ask price). It essentially represents the transaction cost for trading that asset. A narrower spread usually indicates higher liquidity and more active trading, while a wider spread suggests lower liquidity and potentially higher trading costs.

This article explains what the bid-ask spread is, how it works, and its impact on traders and investors.

To understand the spread, it's essential to first grasp what the bid and ask prices represent:

• Bid Price: The maximum price that a buyer is willing to pay for a security.
  

• Ask Price: The minimum price that a seller is willing to accept for that security.
  

The bid-ask spread is the difference between these two prices. It represents the transaction cost or liquidity gap for a given asset.

Consider a stock trading at the following prices:

• Bid: ₹100
  

• Ask: ₹102
  

Here, the bid-ask spread is ₹2. This spread becomes a cost for investors because if you were to buy and immediately sell the stock, you would incur this loss.

The bid-ask spread can be calculated in two ways:

• Absolute Spread:
  Ask Price – Bid Price
  Example: ₹102 – ₹100 = ₹2
  

• Percentage Spread:
  (Ask Price – Bid Price) / Ask Price × 100
  Example: (₹2 / ₹102) × 100 ≈ 1.96%

The spread exists due to the basic mechanics of supply and demand in the market:

• Buyers want to pay less (bid lower).
  

• Sellers want to receive more (ask higher).
  

Market makers, who facilitate trades by quoting bid and ask prices, aim to earn a profit from the spread. This spread also compensates them for the risk of price movement while holding the asset.

Several factors can influence the size of the bid-ask spread:

Liquidity

Highly liquid stocks (like large-cap stocks) tend to have tighter spreads because there are more buyers and sellers.

Trading Volume

Higher trading volume often leads to smaller spreads due to increased competition among traders.

Volatility

Greater price volatility usually results in wider spreads, as market makers face higher risk.

Market Conditions

Economic news, geopolitical events, or corporate announcements can impact spreads temporarily.

Stock Type

Blue-chip stocks generally have narrow spreads, whereas small-cap or illiquid stocks may have wider spreads.

Spreads vary significantly across financial markets:

Note: Spreads in India are influenced by the minimum tick size rules of the respective exchanges (NSE/BSE).

Understanding the bid-ask spread is crucial because it directly affects the cost of trading:

Hidden Cost

Even if brokerage charges are low, a wide spread can increase your trading costs.

Slippage

In volatile markets, you may not get the expected price due to a widening spread, resulting in slippage.

Strategy Consideration

Day traders, especially scalpers, must account for the spread as they rely on small price movements.

You can reduce the impact of the spread in your trading by adopting the following practices:

• Trade high-volume securities
  

• Place limit orders instead of market orders
  

• Avoid trading during volatile periods or after-hours
  

• Use trading platforms that offer real-time spread data

Market makers help maintain liquidity in the market. By continuously quoting bid and ask prices, they ensure that trading continues smoothly. In return, they earn the spread between the buy and sell prices.

In India, stock exchanges appoint authorised market makers for specific securities, especially in less liquid segments.

The bid-ask spread is more than just a technicality; it plays a vital role in determining the efficiency and cost of your trades. A tight spread usually indicates a liquid and active market, whereas a wide spread can signal low liquidity or high volatility. As a trader or investor, being aware of this spread and accounting for it in your strategy is essential for informed decision-making.

This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.