BID-ASK SPREAD EXPLAINED: HOW IT IMPACTS TRADING COSTS

What Is the Bid-Ask Spread?

The bid-ask spread—sometimes referred to simply as the spread—is a fundamental concept in financial markets that represents the difference between the price buyers are willing to pay (the bid) and the price at which sellers are willing to sell (the ask or offer).

For example, if a stock has a bid price of £50 and an ask price of £50.10, the bid-ask spread is £0.10. This seemingly small gap has significant implications, especially for frequent traders or those operating in large volumes.

How Is the Spread Formed?

The spread is generated through the natural dynamics of supply and demand. If many buyers are vying for an asset, the bid rises. Conversely, if sellers dominate, the ask may be lowered to encourage purchases. Market makers—financial institutions or individuals who provide liquidity—play a key role by continuously quoting buy and sell prices.

Why Does the Bid-Ask Spread Matter?

The size of the spread affects how much you pay or receive when buying or selling an asset. Wide spreads often indicate less liquidity or more volatility, leading to higher costs when trading. Narrow spreads often point to a highly liquid market, where trading costs are minimal.

Spread in Different Asset Classes

• Equities: In highly traded stocks like Apple or BP, the spread is often minimal. However, lesser-known or thinly traded stocks have wider spreads.
• Forex: This market generally has very tight spreads due to high liquidity, especially in major currency pairs like EUR/USD.
• Fixed Income: Bond markets can have variable spreads, particularly in less actively traded corporate bonds.
• Cryptocurrencies: Spread sizes can vary widely, influenced by volatility and the specific exchange used.

Retail vs Institutional Impact

Institutional investors often negotiate better rates or trade in dark pools, reducing the impact of the spread. Retail traders, on the other hand, accept publicly quoted bid and ask prices, making them more susceptible to wider spreads and thus, higher trading costs.

Key Takeaway

The bid-ask spread may seem minor, but it has a concrete effect on your trading experience and investment performance. Knowing how it operates can empower investors to make more efficient and potentially more profitable trades.

What Determines the Width of the Spread?

The width of the bid-ask spread varies depending on several interrelated factors. Understanding these elements helps traders gauge when and where to execute transactions most cost-effectively.

1. Liquidity

Liquidity is perhaps the most important determinant of spread size. In liquid markets, where many buyers and sellers are actively trading, spreads tend to be narrow. Conversely, in illiquid markets, the lack of participants leads to wider spreads. For example, government bonds typically have tighter spreads than high-yield corporate bonds due to more active trading.

2. Volatility

Volatile markets often feature wider spreads. When asset prices swing rapidly, market makers increase spreads to protect themselves against unfavourable price shifts between the time of quoting and execution.

3. Trade Volume

Assets with high daily trading volumes typically have smaller spreads. The frequent exchange of shares or units creates a more predictable pricing environment, encouraging market makers to quote narrower spreads.

4. Market Hours and Timing

The time of day can also influence the spread. During off-hours or at the market open, spreads can be wider due to lower participation. Midday trading sessions, particularly during overlap of major markets (like London and New York in forex), tend to have narrower spreads.

5. Market Maker Strategy

Market makers adjust spreads based on perceived risk, regulatory requirements, and their inventory levels. In times of uncertainty or limited opposing orders, they widen spreads to minimise risk exposure.

6. Information Asymmetry

If one party holds material information not yet priced in by the market (known as adverse selection), market makers may widen spreads to compensate for the additional risk. This is common in less transparent markets or prior to major earnings announcements.

7. Asset Type and Exchange

Different asset classes and trading venues inherently carry different spread profiles. For example, spreads in over-the-counter (OTC) markets are generally wider due to reduced regulatory oversight and transparency compared to centralised exchanges.

How to Anticipate Spread Changes

Traders can monitor indicators like order book depth, volume, and implied volatility to anticipate potential spread changes. Many sophisticated trading platforms also offer real-time spread monitoring tools and alerts.

Conclusion

Spread dynamics are multifactorial and constantly changing. By understanding the underlying causes, traders and investors can time their entries and exits more judiciously, thereby reducing costs and improving performance.

How the Bid-Ask Spread Affects Traders

The bid-ask spread is more than a technical feature—it directly translates into real costs for both individual and institutional investors. Understanding its effect allows traders to make informed decisions and manage their positions more efficiently.

1. Direct Trading Costs

Each time an asset is bought or sold, the trader pays the spread. For example, if the ask price is £100 and the bid is £99.90, buying at £100 and immediately selling incurs a £0.10 per share cost. Multiply this across thousands of shares or frequent trades, and the cumulative cost becomes material.

2. Slippage and Execution Price

Wider spreads can lead to greater slippage, where the executed price is worse than the expected price. This poses a significant issue during moments of high volatility or low liquidity. Limit orders can reduce slippage exposure but may take longer to fill.

3. High-Frequency and Daily Trading

High-frequency traders (HFTs), intraday traders, and scalpers are especially sensitive to spread size. For them, even a few basis points in extra cost can materially impact overall profitability. Many build proprietary algorithms specifically to account for and exploit spread patterns across venues.

4. Long-Term Investors

While long-term investors might not notice the impact day-to-day, wide spreads can still affect cumulative returns over time, especially in illiquid securities. Minimising execution costs on large trades can add meaningful value to a portfolio's performance.

5. Strategy Implementation

Traders building positions based on momentum, arbitrage, or statistical models often need to factor spreads into their risk-reward calculations. A seemingly profitable opportunity may become unviable once trading costs are accounted for.

6. Spread as a Market Signal

Some traders use the bid-ask spread as a sentiment indicator. A widening spread may signal impending volatility or dwindling interest in a security, while narrowing spreads could imply improving liquidity and rising confidence.

Reducing the Cost Burden

Investors can employ several tactics to reduce the impact of spreads:

• Use limit orders: Avoid paying the ask price entirely by specifying your maximum purchase price.
• Trade during peak times: Increased liquidity during these hours can minimise spreads.
• Evaluate broker options: Different brokers offer different order routing, liquidity access, and pricing models.
• Consolidate trades: Fewer, larger transactions can be more cost-effective than frequent small ones.

Conclusion

Though often overlooked by novices, the bid-ask spread plays a pivotal role in determining transaction costs. Whether you're a day trader or a long-term investor, understanding and navigating spreads can lead to more efficient and profitable trading strategies.