- Bid-ask spread is the amount (in rupees or paise) by which the best ask rate (lowest sell price) exceeds the best bid rate (highest buy price) of a security at any given moment.
- Trading volume and volatility are two main determinants of the width of the bid-ask spread.
- In a liquid market, with high trading volume (i.e., a large number of units or securities being traded), the bid-ask spread is low.
What is Bid-Ask Spread?
It is used for trading and to read an order book. The lower the bid-ask spread, the higher the chance of a transaction between the buyer and seller.
Example of Bid-Ask Spread
If the best ask rate is Rs 5,252 and the best bid rate is Rs 5,250, then the bid-ask spread is Rs 2.
Factors affecting the Bid-Ask Spread?
The main factor determining the width of the bid-ask spread is the trading volume. Another critical factor affecting the bid-ask spread is market volatility. Stocks that are thinly traded generally have higher spreads. Also, the bid-ask spread widens during times of high volatility.
Liquidity and Bid-Ask Spread
The width of the bid-ask spread differs from one asset to another because of the difference in liquidity. In a liquid market, with high trading volume (i.e., a large number of units or securities being traded), the bid-ask spread is low, as there are many buyers and sellers. So, the bid-ask spread may tell us how liquid a security is, as the lower the bid-ask spread, the more liquid the security.
An example to showcase the relationship between liquidity and the bid-ask spread is that of the currency market. Current is invariably considered the most liquid asset. In the currency market, the bid-ask spread is one of the smallest.
On a trading day, at any given moment, in a security’s trade order book (refer table), there will be a list of different bid rates or prices and different ask rates or prices of different bidders and sellers, respectively.
Bid rates are arranged highest to lowest, i.e., the highest buy price (most beneficial for a potential seller, hence best bid price) to the lowest buy price (least beneficial for a potential seller), quoted by bidders for that security. Ask rates, on the other hand, are arranged from the lowest sell price (most beneficial for a potential buyer, hence best ask price) to the highest sell price (least beneficial for a potential buyer).
Once a trade is made, the rates in the queue climb up the order book.