Generally, the smaller a stock’s bid-ask spread, the more liquid it is.
What Are Bid and Ask Prices in the Stock Market?
When it comes to stock trading, a bid is the highest price a buyer is willing to pay for a share of a stock, while an ask is the lowest price a seller is willing to accept for a share.
Bids represent the demand side of the stock market, while asks represent the supply side. When a stock has more buyers (bids) than sellers (asks), its trading price goes up until supply and demand become balanced. Similarly, when a stock has more sellers than buyers, its price falls until demand meets supply.
A stock’s bid-ask spread is the difference between the highest price a buyer will pay for it and the lowest price a seller will accept for it.
What Is a Bid-Ask Spread and How Does It Relate to Liquidity?
A stock’s bid-ask spread (sometimes just called the spread) is the difference between the bid and ask prices. The smaller the bid-ask spread for a given security, the more liquid that security is; the larger the spread, the less liquid it is. In other words, stocks with more total buyers and sellers tend to have smaller spreads and thus be easier to trade efficiently.
When a trader purchases a stock, they pay the ask price—the lowest price a seller will accept at the time. When a trader sells a stock, however, they receive only the bid price. For this reason, if a trader was to buy a stock with a bid-ask spread of 10 cents and then immediately sell it, they would lose 10 cents as a result.
Who Benefits From Bid-Ask Spreads? Where Does the Difference Go?
It may seem confusing that a trader has to sell a stock at its bid price rather than its ask price—after all, they’re the one selling the stock.
In reality, however, individual traders don’t buy from or sell to other individual traders—invisible middlemen known as market makers facilitate each transaction. They buy shares from traders who need to sell, and they sell shares to traders who need to buy.
These entities exist to provide the liquidity necessary for individual traders to be able to execute buy and sell orders instantly instead of having to wait to be matched with a trader in the opposite position. At any given time, a market maker holds enough shares of the company in question that it can execute both buy and sell trades nearly instantly.
In exchange for the service they provide, market makers get to pocket the bid-ask spread from each transaction. This is why individual traders have to buy at the ask price and sell at the bid price.
Bid and Ask Example
Let’s say a fictional company called Acme Adhesives is currently trading at $45 dollars a share. Acme is a popular company with a high daily trading volume, so it doesn’t have a very large bid-ask spread. The bid price is $44.98, and the ask is $45.02.
A trader wants to buy ten shares, so they pay $450.20—the ask price multiplied by 10 shares. The market maker that facilitates this transaction profits by $0.40 (the difference between the ask price and the bid price multiplied by 10 shares) as a result of the trade.