A difference between asking price and price paid for an asset on the market. The bid-ask spread simply refers to the difference between what a buyer will pay and what a seller will accept. A seller will be offered the highest price, while a buyer will be offered the asking price.

Understanding Bid-Ask Spreads

The market's perception of a securities price at any time is unique. It is important to consider the two main players in any market transaction: the price taker (trader) and the market maker/counterparty (counterparty), to understand why there is an "ask" and "bid."

Many market makers may be employed in brokerages. They offer securities for sale at a certain price (the asking price), and they will also bid on securities for a particular price (the bidding price). An investor will accept the asking or bid price when they initiate a trade. Financial brokerages refer to this as "crossing the spread" when they claim that their revenues come from traders who "cross the spread."

The bid-ask spread measures the demand and supply for an asset. The ask can be interpreted as the demand for an asset, while the bid represents the supply. If these prices are different, the price action indicates a change in supply or demand.

Supply And Demand

Before understanding the basics of spread, investors must first understand supply and demand. The supply refers to the quantity or abundance of an item on the market, such as stock available for sale. The willingness of an individual to pay a certain price for an item or stock.

The bid-ask spread indicates where sellers will sell, and buyers will buy. A tight bid-ask spread could indicate well-liquidity security that is actively traded. A wide bid-ask spread could indicate the opposite. The spread may increase if there is a large supply or demand imbalance and less liquidity. Spreads for popular securities, such as Google stock, Netflix stock, and Apple stock, will be lower (e.g., Apple stock, Netflix stock, and Google stock will have a lower spread, while stocks that are not easily traded might have a larger spread.

A Sample Of The Bid-Ask Spread

Spread is the difference between a security's asking price and the bid price. Morgan Stanley Capital International (MSCI) wants to buy 1,000 shares of XYZ stock for $10. Merrill Lynch, on the other hand, wants to sell 1,500 shares for $10.25. The spread is between $10.25 (or 25 cents) and $10.

A single investor would see this spread and know that if they wanted to sell 1,000 shares, they could do so for $10 by selling to MSCI. The same investor could also see that Merrill Lynch offers 1,500 shares for $10.25. Supply and demand determine the size and price of the stock. There will be more buyers and more investors than sellers.

How the Spread is Matched

A computer can match buyers and sellers on the New York Stock Exchange (NYSE). In some cases, however, the computer may match buyers and sellers on the exchange floor with a specialist in the stock. This person will post offers and bids for the stock without buyers or sellers to maintain orderly markets. A market maker on the NASDAQ will use a computer program to post bids or offers. This is essentially the same job as a specialist. There is no floor. All orders are electronically marked.

Obligations to Placed Orders

If a firm places a top ask or bid and is hit with an order, it must follow its posting. If MSCI offers 1,000 shares of stock at the highest price and the seller orders 1,000 shares, MSCI must honor the offer. Ask prices are the same. The bid-ask spread is always in the investor's favor, regardless of whether they are selling or buying. An investment asset's overall supply and demand determines the price differential or spread between the ask and bid prices. This affects the asset’s trading liquidity.

Conclusion

Bid-ask spread represents a negotiation in process. Trader success depends on their willingness to stand up and take the initiative in the bid-ask process. Limit orders are a good way to do this. Executing a market order with no concern for the bid-ask or insisting on a limit essentially confirms another trader's offer, creating a return to that trader.