When you place an order to buy or to sell an asset on the open market, there is always another side of the same trade. In essence for you to buy a security, someone has to sell. There is always a buyer and seller for every transaction on the market. The bid-ask spread is the difference between the price the seller is asking and the price at which the buyer is bidding.
Spread = Ask Price – Bid Price
Depending on the asset that you are trading, and its liquidity the spread can be wider or narrower. Securities that are highly demanded usually have a narrow bid-ask spread. Usually the greater the bid-ask spread the more illiquid a security is.
What can influence the bid-ask spread?
There are a few factors that can influence the bid-ask spread. One and perhaps the most important is volume. Volume is the amount of orders that are processed for any given security. If a security is selling for a certain price and there are either too many orders to sell or to buy, the spread is usually adjusted accordingly. There are a few factors that can influence the bid-ask spread. Perhaps the most important that we have seen is liquidity of a particular security. Volatility can also have a tremendous effect on the spread. Usually the higher the volatility, the larger will be the difference between the bid and ask. This is one of the reasons market makers tend to be extremely profitable when the volatility is higher.
How does the bid-ask reflect liquidity?
The bid-ask spread is in essence a measure of liquidity of a certain security. The narrower the spread, the more liquid a security is. This is an important aspect to consider especially when you buy illiquid securities. Due to the low volumes traded in some securities the bid-ask spread might be too wide. For that reason it is important to use a limit order vs market order. A limit order is the best way to trade an illiquid security. If you place a market order on certain securities that are thinly traded, you do not know what the ask price is. You might have another trader or investor on the other side asking a much higher price.
How do market makers make money processing your orders?
Well when you initially submit an order, to buy or sell a security, your broker will fill that order on your behalf. Brokers will ask market makers to buy or sell that specific security, essentially representing you. Market makers make money by buying and selling securities, taking advantage of the fluctuations in the bid-ask spread.
The larger the spread, the more profit they make. This is one of the reasons why volatility increases market maker profits. When a security experiences high volatility, the bid-ask spreads widens. Market makers take advantage of this, essentially buying low and selling high. If the bid-ask spread is wider, they get a bigger cut of each trade.
These are just a few considerations on how the bid-ask spread might influence your order placement. Keep in mind that the bid-ask spread is a representation of the demand and supply dynamics of a certain security. When you place an order, try to keep in mind how the spread relates to that particular security.
In general we often advise to place limit orders even if it is a highly traded security. This allows you to control your entry or exit price, in a simple way. If you are planning on trading certain derivatives such as options, limit orders are also advisable. The spread in options tend to be very wide, and to avoid overpaying or underselling you should use limit orders.
Image source: Youtube