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What Are Bid-Ask Spreads?

Bid-ask spreads measure the difference between what an investor will pay and what a seller will accept for a security. The buyer pays the “bid” price, while the seller receives the “ask” price. The difference between the two (the “spread”) covers the costs of facilitating stock market transactions. 

Bid-ask spreads, explained

Think of bid-ask spreads as an investment markup. Sellers receive the lower price (bid) while buyers pay the higher price (ask). The spread, or difference, compensates market makers, brokers and stock specialists for matching buyers and sellers. 

You can find bid-ask spreads in the stock market, options and futures trading and even forex. However, you won’t see bid-ask spreads for mutual funds, as buyers and sellers pay the same price for these securities. 

How the bid-ask system works

Stock exchanges like the NYSE and Nasdaq work with brokers, stock specialists and market makers to establish bid and ask prices. The two are never the same, with ask prices typically higher than bid prices. When a security sells, the broker or specialist scoops up the spread as their profit for facilitating and executing trades. 

When you trade highly liquid securities like Apple and Google, bid-ask spreads may be as low as a penny. But since market makers work harder to match buyers for less liquid stocks, like small-cap stocks, the spread may be higher.

Bid-ask spread example

Say that Awesome Stock currently has a bid price of $15 and an ask price of $20. The spread, or difference between the two prices, would be $5. 

You can also calculate the bid-ask percentage by dividing the spread by the lowest ask price. In this example, the bid-ask percentage would be 25% ($5/$20 x 100%).

How does a security’s bid-ask spread affect you?

You can think of bid-ask spreads as a measure of supply and demand, where bid prices represent demand and ask prices represent supply. When the two prices move, the new spread reflects changing supply and demand. 

Alternatively, you can look at bid-ask spreads as an indicator of market liquidity. When a given security sees greater liquidity, the spread tends to tighten. Conversely, unknown, unpopular or small-cap securities may see much wider spreads. 

Market makers may also set larger spreads on securities that carry more risk due to liquidity or volatility concerns. For example, options and futures contracts may see larger spreads (percentage-wise) more liquid markets like forex and equities. 

Investors can use this understanding of bid-ask spreads to scrutinize potential investments. For instance, if a given security has chronically large bid-ask spreads, you may ask why – perhaps it’s more volatile or less liquid than your risk tolerance can take. 

What this means for you

It’s possible to reduce the drag of bid-ask spreads on your portfolio. (For instance, by trading less often or using limit orders.) However, in a long-term, buy-and-hold approach, bid-ask spreads shouldn’t impact your long-term gains too much. 

Disclosures

Q.ai is the trade name of Quantalytics Holdings, LLC. Q.ai, LLC is a wholly-owned subsidiary of Quantalytics Holdings, LLC ("Quantalytics"). Quantalytics offers automated financial advice tools through Quantalytics Investment Advisors, LLC ("QAI"), an SEC-registered investment advisor. QIA’s investment advisory services are ONLY available only to residents of the United States. Disclosures concerning QIA’s investment advisory services are available on its Form ADV filed with the SEC. The content in this newsletter is for informational purposes only and does not constitute a comprehensive description of Q.ai's investment advisory services.

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