Complete list
Bid-Ask Spread
What is the Bid-Ask Spread?
The bid price refers to the highest price a buyer is willing to pay for a security, while the ask price represents the lowest price a seller is willing to accept. The bid and ask prices together constitute the basis for the bid-ask spread.
The bid-ask spread is calculated by subtracting the bid price from the ask price.
The formula goes as follows:
Bid-Ask Spread = Ask Price - Bid Price.
Significance of the Bid-Ask Spread
There are two major significances that bid-ask spread offers the traders.These are:
- Indicator of Market Liquidity: A narrower bid-ask spread generally indicates higher liquidity in the market. It suggests that there is a smaller gap between what buyers are willing to pay and what sellers are asking for, making it easier to enter or exit positions without significant price fluctuations.
- Source of Transaction Costs: Traders and investors face transaction costs when they buy or sell assets. The bid-ask spread is a primary component of these costs. The difference between the bid and ask prices is essentially the cost of executing a trade immediately.
You can explore our course on Systematic Options Trading to learn more about spread trading strategies.
Factors Influencing Bid-Ask Spread
Going further, let us find out which factors influence the bid-ask spread and therefore, are necessary for the traders to keep a check on. These factors are:
- Market Volatility: In periods of high market volatility, bid-ask spreads tend to widen. This is because market participants are uncertain about the future price movements, leading to increased risk perception.
- Asset Liquidity: Less liquid assets, such as certain small-cap stocks, may have wider bid-ask spreads because there are fewer buyers and sellers in the market.
- Trading Volume: Higher trading volumes often lead to narrower bid-ask spreads due to increased market activity and competition among buyers and sellers.
- Economic Events: Important economic announcements or events can impact bid-ask spreads. For example, during earnings releases, bid-ask spreads for stocks can widen as uncertainty about the company's performance increases.
Types of Markets and Bid-Ask Spreads
Here are the types of markets and explanation of how bid-ask spread differs for each.
- Equities Market: In the stock market, bid-ask spreads can vary widely based on the company's size, trading volume, and market conditions. Blue-chip stocks typically have narrower spreads compared to penny stocks.
- Foreign Exchange (Forex) Market: The bid-ask spread in the forex market is usually very tight due to its high liquidity. Major currency pairs often have spreads as low as a few pips.
- Cryptocurrency Market: Bid-ask spreads in the cryptocurrency market can be relatively wider than traditional markets. This is partly due to the fragmented nature of cryptocurrency exchanges and their varying levels of liquidity.
Bid-Ask Spread and Trading Strategies
Do you know of the trading strategies that can be used with bid-ask spread?
Let us see some examples below:
- Scalping: Scalpers aim to profit from small price movements by making multiple trades in a short time frame. They prefer markets with tight bid-ask spreads for quick entry and exit.
- Day Trading: Day traders capitalize on short-term price fluctuations. Tight spreads are crucial for executing multiple trades throughout the day efficiently.
- Swing Trading: Swing traders hold positions for several days or weeks. While spreads are still important, they might have a slightly lower impact on this strategy compared to day trading.
- Long-Term Investing: Investors with a long-term horizon are less affected by bid-ask spreads since their focus is on the overall performance of the asset over time.
Bid-Ask Spread vs. Spread Betting
So, what is the difference between bid-ask spread and spread betting?
Let us find out with this interesting table below.
|
Aspect |
Bid-Ask Spread |
Spread Betting |
|
What Is It? |
The Bid-Ask Spread is the cost you pay for trading. It's the difference between the price you can sell an asset for (bid) and the price you can buy it for (ask). |
Spread Betting is like making a prediction. You're not buying or owning anything; you're making a bet on whether an asset's price will rise or fall. |
|
Costs |
When you trade, you pay the Bid-Ask Spread as a direct cost. It's like a fee for the transaction. |
With Spread Betting, the cost is the spread itself—the difference between the buy and sell prices. It's part of every bet you place. |
|
Rules |
Bid-Ask Spread trading operates under the rules of the specific market you're trading in. |
Spread Betting is governed by financial betting regulations. There are specific rules for how these bets are placed and managed. |
|
Short Selling |
In Bid-Ask Spread trading, you can sell assets you don't own (short selling). |
In Spread Betting, you can bet on assets decreasing in value without actually owning them. |
|
Freedom |
Bid-Ask Spread trading might offer some flexibility, but it's tied to specific markets. |
Spread Betting provides flexibility in terms of strategy. You can bet on various aspects of market performance. |
|
Getting In/Out |
In Bid-Ask Spread trading, trade execution depends on market conditions and liquidity. |
Spread Betting allows you to enter and exit bets based on the range between the buy and sell prices. |
Bid-Ask Spread and Market Efficiency
Let us find out what role does market efficiency play while considering the bid-ask spread for trading.
- Efficient Market Hypothesis: The bid-ask spread reflects market efficiency. In highly efficient markets, spreads are expected to be narrower because all available information is already priced into the assets.
- Informational Efficiency: A narrower bid-ask spread can indicate that market participants have access to and are actively trading on the latest information, making the market more informationally efficient.
Limitations and how to mitigate the impact of the same?
Below are a couple of limitations of using bid-ask spread and the ways to mitigate the same.
|
Limitation of Bid-Ask Spread |
Ways to Overcome |
|
1. Market Volatility: Wide spreads during high volatility can increase transaction costs. |
- Use Limit Orders: Place limit orders to buy/sell at a specific price. This can help you avoid unfavorable executions during volatile times. |
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2. Illiquid Assets: Less liquid assets often have wider spreads, making trading more expensive. |
- Avoid illiquid assets: Research and choose assets with higher trading volume and liquidity to reduce spread impact. |
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3. Bid-Ask Bounce: Frequent price moving between bid and ask levels can lead to inefficient executions. |
- Use Smaller Order Sizes: Break down larger orders into smaller sizes to reduce the impact of bouncing. - Monitor Order Book: Keep a close eye on the order book to gauge potential price movements and execute orders strategically. |
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4. High-Frequency Trading (HFT): HFT strategies can contribute to spread fluctuations and market manipulation concerns. |
- Understand HFT Impact: Stay informed about HFT strategies and their potential impact on spreads. - Trade with Caution: Exercise caution when trading during periods of high HFT activity, and consider longer time frames for investment. |
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5. Economic Events: Bid-ask spreads can widen during economic announcements, leading to uncertain execution prices. |
- Trade After Announcements: Consider waiting until after the announcement to trade, once the market stabilizes. - Use Advanced Orders: Utilize advanced order types like fill-or-kill orders to execute trades quickly at a specified price. This can help since it can lead to a greater control over your trade execution at the specified price. |
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6. Broker Dependence: Bid-ask spreads can vary between brokers, impacting trading costs. |
- Compare Broker Spreads: Research and compare spreads offered by different brokers to choose the one with competitive rates. |
You can explore our course on Systematic Options Trading to learn more about spread trading strategies. With this course, you can learn to backtest spread strategies.