Bid-Ask Spread

The bid-ask spread is the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask). This spread represents a transaction cost for investors and a source of profit for market makers who stand ready to buy and sell securities. For example, if a stock has a bid of $49.95 and an ask of $50.00, the spread is $0.05 or 0.1% of the stock price. If you buy at the ask and immediately sell at the bid, you'd lose this spread. The spread is a cost of doing business in securities markets, akin to a commission or fee. Spread width depends on several factors. Liquidity is paramount - heavily traded stocks like Apple or Microsoft have penny-wide spreads, while thinly traded stocks might have spreads of several percent. Volatility affects spreads because market makers face more risk during turbulent markets. Time of day matters too; spreads are often wider at market open and close. Market makers profit by earning the spread. They buy at the bid from sellers and sell at the ask to buyers. This arbitrage-like activity is their compensation for providing liquidity and taking on the risk of holding inventory. Competition among market makers keeps spreads tight in liquid markets. For investors, understanding spreads helps in several ways. It encourages using limit orders to avoid paying unnecessarily wide spreads. It highlights the hidden cost of trading illiquid securities. It explains why frequent trading can significantly impact returns - each round trip costs the spread. The evolution of electronic trading has dramatically reduced spreads over the past few decades. What once cost an eighth of a dollar (12.5 cents) per share now often costs a penny. This reduction in trading friction has benefited investors, making it more economical to implement investment strategies requiring frequent transactions.