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What is the Bid-Ask Spread?

Written by Nickel - 5 Comments

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It’s widely recognized that the transaction costs incurred by investors are made up of two primary components: brokerage fees (i.e., commissions), and the bid-ask spread. While most people are familiar with brokerage fees, fewer people are familiar with the concept of the bid-ask spread.

The bid-ask spread, sometimes referred to as the bid-offer spread, refers to the difference between the prevailing price at which you could sell a particular investment (the bid price) and the price at which you could buy it (the ask price). In other words, we’re talking about the highest price that a buyer is willing to pay for an asset, and the lowest price that a seller is willing to accept.

The difference between the bid price and the ask price is the referred to as the “spread,” and it goes to the so-called “market maker.” Market makers are firms that provide market liquidity and help to smooth out buyer/seller imbalances (and ultimately profit) by standing ready to buy assets at the bid price and to sell them at the ask price.

The reason that he bid-ask spread matters to people like you and me is that whenever you make a trade, you’re instantaneously “in the hole” by a small amount, even before we consider brokerage fees. It’s worth noting that the bid-ask spread is typically larger on thinly-traded (i.e., relatively illiquid) investments such as micro-cap stocks as compared to more widely traded (i.e., relatively liquid) investments.

Published on October 13th, 2009 - 5 Comments
Filed under: Saving & Investing

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Comments (scroll down to add your own):

  1. Not sure I understand the “market maker”‘s role, but there is no such thing as a free-lunch, so I bet he gets burned every now and again (if the markets were “fair”).

    Also, if I call my broker and tell him to sell XX shares for $10, there really is no “spread” that I’ll lose, because I set the price right? The only way my transaction goes through is if someone comes up to meet my price (and I’m only out the brokerage fee).

    Comment by Anonymous — Oct 13th 2009 @ 6:23 pm
  2. This is true if you’re using a market order. However, if you are setting a limit order at the current end of the spread, then someone else can “pay” the spread cost. For example, if bid is 10 and ask is 10.01, you can set a buy limit at 10, which won’t get immediately filled like a market order. However, if someone else then comes and puts in a sell order at market, they could sell it to you at 10 without changing the bid-ask. Thus, you just bought at 10 and can still sell at 10.

    As a basic concept, yes, but you simplified it a little too much.

    Comment by Anonymous — Oct 13th 2009 @ 9:15 pm
  3. Not necessarily true. Example:

    You want to buy 5 shares of XYZ stock at $10 a share. A seller is willing to sell you 5 shares of XYZ stock at $9.98 a share. You get your 5 shares of XYZ stock, the seller gets their money, and the broke gets the 2 cent difference.

    Comment by Anonymous — Oct 13th 2009 @ 9:25 pm
  4. Never heard of the bid-ask spread, but interesting article nevertheless.

    Comment by Anonymous — Oct 15th 2009 @ 6:03 pm
  5. Good article. How about another one that lays out step by step how to buy and sell options using a broker’s web site.

    Comment by Anonymous — Oct 16th 2009 @ 2:23 pm

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