BID-ASK SPREAD EXPLAINED AND ITS IMPACT ON TRADING COSTS

What is Bid-Ask Spread?

The bid-ask spread is the difference between the price a buyer is willing to pay for an asset (the bid) and the price a seller is willing to accept (the ask or offer). It is a fundamental concept in financial markets and plays a central role in determining trading costs and market efficiency.

In most trading venues, whether you're dealing with shares, forex, commodities, or cryptocurrencies, there are two quoted prices at any given moment:

• Bid Price: The highest price that a buyer is willing to pay for a particular asset.
• Ask Price: The lowest price at which a seller is willing to sell the same asset.

The spread is the difference between these two prices. For example, if the bid for a stock is £100.50 and the ask is £100.60, the spread is £0.10. While this may seem minimal, it becomes significant, particularly for frequent traders or high-volume orders.

Bid-ask spreads are present across all markets and serve as the price of liquidity. A narrower spread usually indicates a highly liquid market with many participants actively buying and selling, while a wider spread suggests lower liquidity, higher volatility, or greater uncertainty regarding the asset's true value.

A market maker—usually a bank or brokerage firm—often provides both the bid and ask quotes and facilitates market liquidity by continuously buying and selling to meet order flow. As compensation for this service, they profit from the bid-ask spread. In over-the-counter (OTC) or less transparent markets, this spread may also include additional fees or premiums.

The size of the bid-ask spread can depend on various factors:

• Liquidity: Highly traded assets such as major shares or currency pairs typically have tight spreads.
• Market Volatility: During times of uncertainty or rapid price movement, spreads tend to widen.
• Time of Day: Certain times, like the close of trading or low-volume periods, can result in wider spreads.
• Order Size: Larger orders may experience wider spreads, especially in markets with limited depth.

Understanding the bid-ask spread is essential for traders and investors because it represents a hidden cost that can impact transaction efficiency and profitability. This leads us to consider exactly how the bid-ask spread affects trading costs, explored in the next section.

How Spread Influences Trading Costs

The bid-ask spread is often considered an implicit cost of trading. While brokerage fees and commissions are typically disclosed and understood, the spread is a frequently overlooked factor that can significantly affect trading performance, particularly during active market engagement or high-frequency trading strategies.

Let us consider a simple example to understand how the spread influences cost. Suppose you want to buy a stock where the bid price is £100 and the ask price is £101. The moment you purchase at the ask (seller’s price), you are already £1 “down” since—if you immediately reversed the trade—you could only sell it for £100. That £1 difference, known as the spread, represents your trading cost, excluding any other fees.

Components of Trading Cost Through Spread

The impact of the spread on trading cost becomes more pronounced in different scenarios:

• Short-Term Trading: For day traders or scalpers who enter and exit positions frequently, even a 0.5% spread can add up to a substantial amount over multiple trades.
• Large Transactions: Institutions executing large trades may experience ‘market impact’, where fulfilling the order at a single price isn't possible, leading to higher average spreads.
• Low-Liquidity Assets: Trading in securities with limited volume can involve spreads of 2–5% or more, severely affecting net returns unless offset by large price moves.

Effective Spread and Realised Spread are two other related metrics that traders track to analyse trading efficiency. These help in calculating the actual cost versus quoted cost by assessing how much slippage occurred during the order execution process.

For algorithmic and institutional trades, these spreads are scrutinised as part of Transaction Cost Analysis (TCA). Algorithmic trading systems are often designed to exploit narrow spreads and seek out liquidity without triggering large price movements, further emphasising the strategic role of spreads in advanced trading systems.

Relationship with Liquidity and Market Efficiency

Narrow spreads often indicate high liquidity and more efficient markets. For example, large-cap stocks listed on major exchanges such as the London Stock Exchange typically exhibit spreads of just a few basis points. On the other hand, emerging market equities, thinly traded bonds, or exotic currency pairs can demonstrate expansive spreads.

As a result, spreads serve as both a cost measure and a market quality metric. Efficient markets have tighter spreads, allowing participants to transact with minimal friction and better price discovery, which is vital for all financial participants from retail investors to institutional fund managers.

In conclusion, the bid-ask spread constitutes a real cost that all traders should factor in when assessing potential returns. Awareness of the spread’s size and variability by asset, time, and condition is key to effective cost management and better investment decisions.

Managing the Spread in Your Strategy

Given the impact of the bid-ask spread on trading costs, it becomes essential for investors and traders to adopt deliberate strategies to minimise these effects. Although the spread is sometimes unavoidable, certain practices and tools can help reduce its influence on a portfolio or trading account.

1. Choose Liquid Markets

One of the most straightforward ways to minimise spread-related costs is to trade assets that are highly liquid. Stocks of large-cap companies, benchmark index ETFs, and major currency pairs usually offer the tightest bid-ask spreads. Their high trading volumes lead to better price discovery and lower trading friction.

Group exposure towards baskets of instruments like index funds or sector ETFs can also reduce costs from wide spreads often seen in niche individual stocks.

2. Use Limit Orders

Limit orders allow you to set the specific price at which you’re willing to buy or sell. This control helps avoid executing trades at unfavourable prices above your intended entry or below your desired exit.

• Buying: Setting your buy order at or slightly below the bid helps you avoid crossing the spread unnecessarily.
• Selling: Set your sell order at or above the ask instead of accepting the next available bid.

While a limit order may take longer to execute—especially in volatile or low-volume markets—it prevents you from being charged the full spread outright.

3. Consider Time and Volatility Windows

Spreads tend to widen during periods of market uncertainty or after-hours trading. Executing trades during regular exchange hours, particularly when both domestic and global markets are open, can mitigate this widening effect. For example, trade during overlap windows in the forex market when both London and New York sessions are active.

4. Evaluate Brokerage Platforms and Tools

Some trading platforms offer Level II market data showing order depth and real-time spread movements. This transparency lets advanced users place trades more intelligently. Likewise, low-cost brokerages often offer tight spreads in exchange for slightly reduced service levels.

Many platforms also provide bid-ask spread analysis tools to help optimise trade execution. These allow a trader to time entries and exits carefully to avoid peak spread moments.

5. Balance Spread vs Commission

Zero-commission brokers may compensate with wider spreads to generate revenue. Conversely, commission-based platforms may offer narrower spreads. Optimal cost-efficiency often lies in balancing both models based on your trade size, frequency, and strategy profile.

6. Use of Algorithmic Trading Tools

Professional and high-volume traders increasingly use algorithms that dissect intraday price and volume distributions to trade when spreads are narrow. These tools benchmark execution quality through spread-based metrics, ideal for reducing costs at the institutional level.

In some markets like FX and fixed income, choosing counterparties or liquidity providers offering more competitive pricing on the spread is also a viable strategy.

Effectively managing spread risk is not just about lowering monetary costs—it plays into the broader goal of execution quality, ensuring your strategy retains its edge while managing transaction friction. Spread-conscious trading helps in improving consistency and limiting slippage, both key to sustainable portfolio performance.