What is the bid-ask spread?
– Definition: The bid-ask spread is the difference between the highest price a buyer is willing to pay (the bid) and the lowest price a seller is willing to accept (the ask, also called the offer). It represents the immediate cost of executing against current market quotes and is a basic measure of trading friction.
Key terms
– Bid: the best (highest) price available from buyers right now.
– Ask (offer): the best (lowest) price available from sellers right now.
– Spread: Ask price − Bid price (a money amount).
– Percentage spread: (Ask − Bid) / Reference price (often midpoint or last trade) expressed as a percent.
– Effective spread: a measure of actual transaction cost that compares the execution price to the midpoint of the quoted bid and ask; it captures how much a market order paid relative to the center of the displayed market.
Why the spread exists (short summary)
– Two-sided markets: Buyers and sellers post different prices. A trade only happens when one side accepts the other’s quoted price.
– Market makers and liquidity providers post bids and asks and collect the spread as compensation for facilitating trades and for bearing inventory and execution risk.
– Supply, demand, market structure, and perceived risk all affect the spread’s width. More competition and deeper order books produce tighter (narrower) spreads; illiquid or risky instruments typically show wider spreads.
How to calculate the spread
– Nominal
Nominal spread — the simplest measure. Definition: nominal (or absolute) spread = ask price − bid price. It is quoted in the same currency units as the security.
Step-by-step:
1. Read the inside bid and ask. Example: bid = $10.00, ask = $10.10.
2. Compute nominal spread = 10.10 − 10.00 = $0.10.
Interpretation: nominal spread tells you the raw dollar cost a liquidity taker faces to cross from bid to ask, but it does not account for price level (i.e., percentage impact).
Relative (percentage) spread — expresses the spread as a share of price so you can compare across securities of different prices. Common denominator choices are the midpoint or the ask; using midpoint is typical in academic and market-quality analysis.
Formulas:
– Midpoint = (ask + bid) / 2.
– Relative spread (%) = (ask − bid) / midpoint × 100.
Worked example:
1. With bid = $10.00 and ask = $10.10, midpoint = (10.10 + 10.00)/2 = $10.05.
2. Relative spread = (0.10 / 10.05) × 100 ≈ 0.995%.
Effective spread — measures the actual transaction cost for a trade relative to the midpoint at the time of the trade. This captures whether a trade executed at the bid, ask, or somewhere in between (or even beyond), and it reflects real execution quality.
Standard formula:
– Effective spread = 2 × (trade price − midpoint at time of trade).
– Often reported as absolute value so the sign (buy vs sell) does not cancel costs: Effective spread = 2 × |trade price − midpoint|.
Why the factor 2? A trade exactly at the ask is half the quoted spread above the midpoint; multiplying the deviation from midpoint by 2 converts the one-sided deviation into a round-trip-equivalent spread.
Worked examples:
1. If bid = 10.00, ask = 10.10, midpoint = 10.05.
– A buy market order fills at 10.10. Effective spread = 2 × (10.10 − 10.05) = 2 × 0.05 = $0.10 (same as nominal).
– A buy limit order partially fills at 10.06. Effective spread = 2 × (10.06 − 10.05) = 2 × 0.01 = $0.02.
2. Illiquid example: bid = $2.00, ask = $2.40, midpoint = $2.20.
– Nominal spread = $0.40.
– Relative spread = 0.40 / 2.20 = 18.18%.
– If a sell executes at $2.10, effective spread = 2 × (2.10 − 2.20) = 2 × (−0.10) → absolute = $0.20, or relative = 0.20 / 2.20 = 9.09%.
Measuring cost across multiple trades (volume-weighted)
1. For each trade i, compute effective spread_i = 2 × |trade price_i − midpoint_i|.
2. Compute volume-weighted average effective spread = (Σ volume_i × effective spread_i) / Σ volume_i.
This produces a single number representing average per-share cost against the prevailing midpoint.
Practical checklist for reducing spread-related costs
– Use limit orders when you can wait; they may capture the spread (i.e., earn liquidity) rather than pay
– Use limit orders when you can wait; they may capture the spread (i.e., earn liquidity) rather than pay it. Set the limit at or inside the midpoint for a higher chance of capturing price improvement, and be prepared for non-execution if price moves away.
– Slice large orders into smaller child orders. Breaking a big parent order into multiple smaller trades reduces the chance of moving the quoted price and can access liquidity at multiple price levels. Common slicing rules: fixed-size slices (e.g., 1,000 shares), randomize inter-slice timing to avoid predictability, or use time-weighted strategies.
– Use execution algorithms when available. Volume-weighted average price (VWAP) and time-weighted average price (TWAP) algorithms automate slicing and timing to match market volume or uniform time distribution. Implementation shortfall algos aim to minimize total cost (spread + market impact) by dynamically balancing aggressiveness.
– Trade during higher-liquidity windows. For most equities and ETFs this is mid-morning through mid-afternoon; avoid the open and close unless you need them, because spreads and volatility are typically larger at market open/close.
– Avoid trading immediately around scheduled news releases (earnings, economic data). Spreads widen and price jumps increase the risk of crossing a wide spread.
– Consider midpoint or peg orders if your venue offers them. Midpoint (or midpoint peg) orders execute at the midpoint and can capture half the spread, but they may be slow to fill and can be disadvantaged by hidden liquidity or order priority rules.
– Monitor the order book (depth). A thick order book (multiple price levels with substantial size) usually implies lower hidden costs than a thin book. Watch for imbalance indicators and changes in displayed depth before sending large or marketable orders.
– Account for fees, rebates, and exchange rules. Some venues rebate liquidity provision (making limit orders net profitable after fees), while others charge for taking liquidity. Include these in your cost calculations.
Worked numeric example — volume-weighted effective spread
Assume three trades against contemporaneous midpoints:
– Trade 1: volume = 500 shares; trade price = $10.05; midpoint = $10.00
– Trade 2: volume = 1,000 shares; trade price = $9.95; midpoint = $10.00
– Trade 3: volume = 500 shares; trade price = $10.02; midpoint = $10.00
Step 1 — compute effective spread per trade: effective spread_i = 2 × |trade price_i − midpoint_i|
– Trade 1: 2 × |10.05 − 10.00| = 2 × 0.05 = $0.10
– Trade 2: 2 × |9.95 − 10.00| = 2 × 0.05 = $0.10
– Trade 3: 2 × |10.02 − 10.00| = 2 × 0.02 = $0.04
Step 2 — compute volume-weighted average effective spread:
– Σ (volume × effective spread) = 500×0.10 + 1,000×0.10 + 500×0.04 = 50 + 100 + 20 = $170
– Σ volume = 500 + 1,000 + 500 = 2,000 shares
– VW average effective spread = 170 / 2,000 = $0.085 per share
Step 3 — relative (percentage) VW effective spread = $0.085 / midpoint (use $10.00) = 0.85%
Notes on this example: it assumes midpoints are the best estimate of fair price at each trade and ignores commissions, fees, rebates, and market impact beyond the recorded trade prices.
Practical checklist before sending an order
1. Define urgency: Is immediacy required (market order) or can you wait (limit/midpoint order)?
2. Size vs. book depth: If size > available at best prices, plan to slice or use an algo.
3. Venue and fee structure: Know taker/maker fees and whether midpoint/dark pool options exist.
4. Volatility and news: Check economic calendar and company announcements.
5. Order type: Choose market, limit, midpoint peg, or an algo to balance speed vs. cost.
6. Post-trade review: Compute effective and VW effective spreads over recent trades to assess execution quality.
Limitations and assumptions
– Midpoint-based spread measures assume the midpoint approximates fair value at trade time; in fast markets the midpoint can itself be stale.
– Effective spread captures deviation from midpoint but does not fully separate adverse selection (trading with someone informed) from pure liquidity cost.
– Fees, rebates, and hidden-liquidity mechanics vary by exchange/venue and materially affect realized costs.
Further reading (selection)
– Investopedia — Bid-Ask Spread: https://www.investopedia.com/terms/b/bid-askspread.asp
– U.S. Securities and Exchange Commission (SEC) — Market Structure FAQs: https://www.sec.gov/retail/faq.htm
– New York Stock Exchange (NYSE) — Trading & Market Data: https://www.nyse.com/markets
Educational disclaimer
This information is educational only and not individualized investment advice. It explains concepts and methods for measuring and managing spread-related trading costs; it does not recommend specific trades, securities, or strategies. Consider consulting a licensed professional before making trading decisions.