What is a Bid-Ask Spread?
The stock market is not a lottery. But, individuals, corporations, and governments use the stock market as an auction to buy and sell securities. Understanding bid-ask spreads are crucial to comprehending the various available buying and selling options. Unlike the TV or biscuits you purchase where you are forced to pay the price the seller demands, stock prices are set by both buyers and sellers together.
Just like an auction, the "bid" represents the price a buyer is willing to pay for a share or asset. On the other hand, the "ask" or "offer" is the price that the seller demands for the share, and it is the price believed to be the fair value. The “spread” is the difference between these two values.
The bid-ask spread can be calculated using the bid-ask spread formula, dividing the bid-ask spread by the sale price. The spread represents the transaction cost. While price takers are the ones who buy at the Ask price and sell at the bid price, the market maker buys at the bid price and sells at the Ask price.
How Does the Bid-Ask System Work?
Stock exchanges and broking houses, like IIFL, have a primary role in coordinating bids and asks. These services have a specific cost, which directly affects the stock price. This is similar to delivery fees being added for your products during online shopping.
To determine which trades are executed first, stock purchase or sale orders are processed using a set of rules. If your primary goal is to buy or sell the stock as soon as possible, you can place a market order. This also means that you'll have to accept whatever the market offers at the time.
If you have access to the necessary online pricing systems, you can see the bid and ask prices for a stock. They're never the same; the Ask price is always a few rupees more than the bid price. Usually, the broker managing the transaction keeps it as a profit. However, the commission fees tend to be higher at broking firms as compared to retail brokers.
In reality, the amount of the bid-ask spread is used to pay a variety of costs in addition to the broker's commission. Certain significant corporations, known as "market makers", can set a bid-ask spread by proposing to purchase and sell a particular stock.
For example, a market maker might quote a bid price of Rs 200.40 and an Ask price of Rs 200.45 for company shares, where Rs 200.40 is the buying price and Rs 200.45 is the selling price. The bid-ask spread, in this case, would be Rs. 0.05 per share. The spread, or difference, is beneficial to the market maker since it indicates profit for the company.
Elements of the Bid-Ask Spread
The critical components or elements of a bid-ask spread include:
- As it is a de facto measure of market liquidity, you can book a profit at the right time.
- To make a spread, there should be some friction in the supply and demand for that security.
- Instead of a market order, traders should limit orders to decide the entry point to avoid missing the spread opportunity.
- The bid-ask spread is expensive since two trades may be done simultaneously.
- Bid-ask trades can be made in any kind of security; the most popular being foreign exchange and commodities.
The Bottom Line
The bid-ask spread meaning is the demand-supply for an asset. There are ways to avoid the bid-ask spread, but most investors are better off sticking with this proven method that works, even though it does take a small bite out of their profit. As a beginner, you may seem overwhelmed to apply these advanced strategies. Fortunately, you can consult a broker or brokerage firm like IIFL to help you make the right investment decision.
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Frequently Asked Questions
When you see a bid price for a stock that is a higher price at which someone is willing to buy it, and when you see an Ask price, that is the lowest price at which someone is willing to sell it. A trade is executed when Bid = Ask. In the same way, when you enter a market order, you agree to buy at the Ask or sell at the Bid.
The Bid-Ask spread is the difference between Bid and Ask, and the wider the spread, the less liquid the stock is. A wider bid-ask spread indicates more volatile and less liquid security. Traders may not execute trades as often when there's a large spread, and when they do, the price may jump around more quickly than a more stable stock that only moves a few pennies at a time. It's hard to predict what price you'll get with a market order, and stop orders are less likely to arrive precisely at the stop price you specify.