What is a bid-ask spread?

February 22, 2024 - A bid-ask spread is the difference between the highest price a buyer is willing to buy a security at in a particular market, and the lowest price a seller is willing to sell at. Bid-ask spreads are referred to with securities such as stocks, bonds and particularly currencies where the trading volume is highest. Bid-ask spreads are also commonly referred to in options trading, as traders are looking to enter and exit positions at specific prices usually in the short-term, as opposed to markets with more long-term trading strategies.

In simple terms, a bid-ask spread is the difference between the price you can buy an asset, and the price at which you can sell it. Bid-ask spreads are used as measurements for how liquid and stable a market is.

Bid-ask spreads explained

Bid-ask spreads can be explained by first defining what the ‘bid’ is and what the ‘ask’ is.

Bid – the bid is the highest price that a buyer is willing to pay for a security at any given moment during trading.

Ask – the ask is the lowest price that someone is willing to sell the security for.

For example, take a security which is trading on average at $50 (the mid price). This price will fluctuate, so there will be buyers constantly looking for the lowest price, and sellers for the highest price, as this generates them the most profit.

Sellers might be looking to sell their shares for at least $51, hoping to make a small profit. Buyers might be looking to enter the market at the most at $50, hoping for the market price to increase to at least $51. 

The difference between the bid ($50) and the ask ($51) is $1 – this is the bid-ask spread.

Calculating the bid-ask spread percentage

Bid-ask spreads are usually measured as a percentage.

In order to find the bid-ask spread percentage, you can find it by dividing the ask price by the bid-ask spread, and then multiplying by 100 to find the percentage.

Here is the formula you need to calculate a bid-ask spread percentage.

Using the previous example where the bid price was set at $50 and the ask price at $51, we can calculate the bid-ask spread percentage as follows.

1. The bid-ask spread is $51 minus $50, equalling $1.
2. 1 divided by 51 equals approximately 0.0196. 
3. Multiplied by 100 gives 1.96.

Therefore, given the given a bid price of $50 and an ask price of $51, the bid-ask spread percentage in this scenario is approximately 1.96%

Bid-ask spreads in liquidity

Bid-ask spreads are important measures when it comes to liquidity. 

Due to the bid-ask spread being correlated to the amount of buyers and sellers, bid-ask spreads can be a way of measuring the liquidity of a market.

If a market is highly liquid, then this is usually reflected with lower spreads. If there is assurance that an asset can be bought or sold, due to high liquidity, then it means that the highest price people are willing to buy at, and the lowest price people are willing to sell at, are much closer together.

Take for example the forex market, which has the highest liquidity compared to any other market. The bid-ask spreads in currency exchange are tiny – reaching as low as one hundredth of a percent. 

On the other end of the scale, low liquidity stocks such as penny stocks might have a huge bid-ask spread. This is because the amount of buyers and sellers is low, and the volatility is high. The difference between the lowest price people are willing to sell at, and the highest price people are willing to buy at is vast. 

Furthermore, due to the low liquidity, the volatility will increase if significant activity happens with either buyers or sellers, and the price may change rapidly. Without a market maker, trading the stock may become unsustainable.

Therefore, a wide bid-ask spread is bad, as it may result in traders not being able to exit positions at the right prices, and also not be able to control prices, as once they exit a position, the market can tip.

Market makers in bid-ask spreads

Market makers play a key role in determining the bid-ask spreads. By injecting liquidity into a market, market makers ensure that there are buyers and sellers available.

This is because the buyers and sellers are trading with the capital raised by the market maker – essentially a pot that assures there is always money for a buyer and seller to find their desired price.

A liquidity pool in crypto works in a similar way. By providing a ‘pool’ of crypto from which traders trade from, it means that the market is kept stable and buyers and sellers can always open or exit their positions.

What is a pip in forex?

Due to the bid-ask spread between currencies being so tiny, traders will use ‘pips’ as a unit of measurement (‘pip’ deriving from ‘percentage in point’). A pip is normally 1/100th of 1%, or 0.0001%. Even smaller than this are ‘pipettes, which are 1/10th of a pip.

The exact measurement of a pip can depend on the currency. For currency pairs such as the EUR/USD (the most liquid of all currency pairs in the market), the smallest change that can occur is on the fourth decimal point.

However, for some currency pairs such as the Japanese yen, which has a very low value (1 JPY = 0.006663 USD), the pip is adapted to represent the comparison only up to the second decimal place (0.01%).

Conclusion

Bid-ask spreads are an important part of the financial market, and brokers in all markets will use bid-ask spreads to determine the liquidity and efficiency of a market.

There are many other variations of spreads used, but they are generally all used to take a reading of the market and assess how risky an investment might be.

Liquidity providers play a crucial role in bid-ask spreads, as they reduce volatility and therefore reduce the spread.

We have an ever-growing list of providers which all members have access to. If you are in need of a liquidity provider but aren’t certain on what you need, remember that users can use our Match Matrix tool, as well as our multi-provider request form to help you make a decision.

Author

Caleb is a financial copywriter with a specialisation in fintech and forex. Former copywriter at Barclays and Paysafe. Contributing writer for LiquidityFinder. You can message Caleb here.