Summary - The bid-ask spread is an important investing concept that highlights the relationship between supply and demand and market volume. It is most commonly used in connection with the options and futures markets where prices need to be set for future time periods and buyers and sellers need to be brought together.
The bid-ask spread affects the price at which buying and selling of a particular asset take place. The bid price is the highest price an investor will pay to buy the asset and the ask price is the lowest price the seller will accept to sell. The price differential between the two is the bid-ask spread and that is determined by supply and demand. Popular or heavily traded stocks and highly liquid assets like currencies typically have lower bid-ask spreads than lightly traded securities.
Every investor must consider future price moves when looking at the bid-ask spread. If they are confident that the stock will increase in value beyond the obstacle to profit set up by the bid-ask spread they may consider that a good investment.
When deciding on buying or selling a stock or security, every investor should understand the basic principle behind supply and demand. Informed trading dictates that when buyers outnumber sellers (i.e. demand outweighs supply), the price goes up. Likewise, when sellers outnumber buyers (i.e. supply outweighs demand), the price goes down. For long-term investors, understanding this concept is sufficient when looking for securities that they anticipate will have value now and in the future.
However, active traders are seeking to profit from price action. Therefore, they are more concerned with how much other market participants are willing to buy or sell a stock for in a matter of weeks, days, or even hours. Therefore they are focused not simply, or even primarily on a stock’s market price. They are more concerned about its trading volume and what that may suggest about future price movement. This is one of the reasons trading options and futures has gained popularity in recent years.
In options and futures trading, supply, demand and trading volume come together as financial institutions play the role of market managers on a major stock market such as the New York Stock Exchange. These managers use sophisticated data models to set prices at which a security can be bought or sold to ensure an orderly market. The difference between the highest price the market manager will pay to buy a security (the bid) and the lowest price to sell (the ask) is known as the bid-ask spread.
This article will help define the bid-ask spread and show how it affects traders, including reviewing terminology related to a bid-ask spread and the specific trades that investors use to take advantage of bid-ask spreads.
What is the bid-ask spread?
The bid-ask spread is a tool that market makers at financial institutions use to facilitate buying and selling in a way that facilitates orderly trading.
The bid price is the highest price that investors will pay to buy a security and the ask price is the lowest price they will accept to sell the security. The difference between the two numbers (the ask price will always be higher) is known as the bid-ask spread.
Bid-Ask spread = Ask price – bid price
For example, Merrill Lynch may wish to trade shares of XYZ corporation. They set a bid price of $11 for 1,000 shares and an ask price of $11.50 for 1,500 shares. In this example, the bid-ask spread would be $0.50. Once the bid-ask prices are determined, an investor knows that they can sell 1,000 shares to Merrill Lynch for $11 per share, or they could buy 1,500 shares from Merrill Lynch for $11.50 per share.
But let’s say there are hundreds of investors that are looking to buy shares of XYZ. When this happens, there will be more bids which will drive the purchase price up. Conversely, if there are more investors looking to sell, there would be more offers, or asks. For highly liquid stocks, and other highly liquid assets such as trading a specific currency, the bid-ask spread may be pennies or even fractions of pennies. For illiquid (i.e. less liquid) securities, the bid-ask spread may be several dollars.
Although the bid-ask spread is primarily used to help facilitate options trading, it is also used by institutional investors when a stock is not being actively traded. In this case, market managers will step in with a financial institution’s capital to set bid-ask prices and to fulfill transactions to keep markets moving.
The mechanics of the bid-ask spread in trading
How a buyer and seller are matched is different depending on the stock exchange. On the New York Stock Exchange (NYSE), buyers and sellers are typically matched by a computer. However, in some cases, a specialist in charge of the stock or security in question will match buyers and sellers right on the trading floor. Specialists also fill the void and help ensure an orderly market, by using their own capital to continue to post bids and offers for a stock in the absence of buyers. On the NASDAQ, all the bids and offers are posted by a market maker but they use a computer since NASDAQ is not a physical trading floor.
Once an order is made on a bid or an ask (known as a “hit”), the financial institution that posted the bid or the ask must stand by the posted price. In our earlier example, if Merrill Lynch posts a bid offer to buy 1,000 shares of XYZ at $10 and a seller comes forth, they must buy the shares at that price. The same, of course, will be true of an ask price.
How liquidity affects the bid-ask spread
Liquidity is a measurement of how easily an asset can be bought or sold without affecting the asset’s price. Cash, which can be exchanged quickly for its full value, is considered to be a highly liquid asset. Paying for a car with cash is a good example of the liquidity of cash. Since the car will depreciate in value as soon as you drive off the lot, paying in cash means that the money you paid hasn't lost its value. Conversely, collectibles or paintings have more of intrinsic value and will likely have a more limited market. Therefore, should an owner need to sell these items quickly to raise cash, they would be more difficult to sell and he might have to sell them at a discount.
Important terms related to trading options using a bid-ask spread
As investors look to digest the data and sophisticated information that is involved with the bid-ask spread, there are a few important terms to understand:
Volume (VLM): This tells how many contracts of a particular option were traded during the latest session. It is common for options with large volumes to carry narrower bid-ask spreads due to increased competition.
Implied Bid Volatility (IMPL BID VOL): This is a statistic that attempts to gauge the future uncertainty of price direction and speed on security. For example, if a company was expected to give a poor earnings report, this number might be higher in anticipation of high volatility. This value is calculated by using an options-pricing model such as the Black-Scholes model.
Open Interest (OPTN OP): The number of contracts that have been opened for a particular option. This number will decrease as open trades close.
Delta: This is simply the probability of something happening. So an option with a delta of 40 means that the option has a 40% chance of expiring “in the money” or at the bid or ask price.
Gamma: This is a measurement of the speed that an option’s delta will move if the underlying stock moves one full point.
Vega: This measures how much an option’s price is expected to change if implied volatility changes by one point.
Theta: This measures how much value an option will lose in one day’s time. This is based on the simple idea that all options will lose all time value on their expiration date.
How the bid-ask spread affects traders?
The actual cost of the bid-ask spread to traders is related to the number of shares that are being traded and the size of the spread. It does not reflect the actual market price of a stock. For example, assuming two traded stocks have the same level of liquidity, a stock that trades at $10 and has a penny per share bid-ask spread will have a significantly higher cost than a $100 stock that has a penny per share bid-ask spread.
For stocks, market value is reflected in the bid-ask spread. The bid price is the highest price a buyer will pay to buy a stock and the ask price is the lowest price a seller will accept to sell.
How to calculate the bid-ask spread percentage
To determine the bid-ask spread percentage, you divide the bid-ask spread by the stock’s sale price. A stock that sells for $80 with a spread of two cents will have a spread percentage of:
$0.02/$80 = 0.025%
A $15 stock with a spread of 10 cents will have a spread percentage of:
$0.10/$15 = 0.67%
How do investors profit from the bid-ask spread?
The bid-ask spread can be seen as the barrier that must be breached for investors to make a profit off the stock. With that in mind, the essential question an investor has to ask deals with the price moves of a stock. That is, how likely the stock is to rise above this barrier thus allowing a profit. As an example, if a stock has a bid price of $8 and an ask price of $10, they will have to pay $10 per share to buy the stock. They will need the stock to move to $11 share to make a $1 per share profit. However, if the investor is confident that the stock will rise to $20 per share or higher, they would stand to make a significant profit.
Bid-ask spreads and order types
To take advantage of a bid-ask spread, a trader can place one of these five types of order with a specialist or market maker.
- Market Order– Market orders are orders to immediately buy or sell a security. In order to do this, the order will be filled either at the prevailing ask price (known as “at the market”) or the next prevailing price. When the market order is executed near the current bid price it is a sell order. Conversely, when it is executed closer to the current ask price it is a buy order. For example let’s consider a buyer who wants to take advantage of an ask price of $12 for 1,500 shares, but want to place an order for 2,000 shares. In this example, the buyer would be guaranteed to receive 1,500 shares for the ask price of $12. However, the remaining shares would be sold to him at the next best ask price. This price could be higher than $12. This is the essential risk of a market order. The order is executed immediately, but not necessarily for an “at the market” price.
- Limit Order– A limit order is an order for buying or selling a security at a specific price or lower. In the case of a buy limit order, the trade will only be executed if the ask price reaches the limit price or higher. Sell limit orders will only take place at the bid price or higher. A key concern here is for investors looking to buy because if they are trying to buy at a price that is below the current ask price, then the ask price and the buy price will have to fall at or below the price specified in the limit order for the trade to be executed.
- Day Order– this is an order that is only good for the trading day it is placed on. If the order cannot be filled it is canceled.
- Fill or Kill Order (FOK)– this is an order that has to be filled immediately (like a market order). However, it also needs to be filled in its entirety. So in our example of the investor looking to buy 2,000 shares at $12 per share. They would have to find a seller that was willing to sell 2,000 shares at that price or the order will be canceled.
- Stop Order– this is an order that goes into effect only after a stock passes a certain price. If an investor wants to sell 1,000 shares at $10 per share, they can help ensure that they get as close to that price as possible by issuing a stop order at $10. If the stock hits $10, the stop order would become a market order which would then ensure the stock would be sold. They may not get exactly $10 depending on how many sellers are active. However, this would ensure that the stock is sold. The difference between a stop order and a limit order is that a stop order is based on prices that are conditional, whereas a limit order is based on a price that is only seen by the market if the stop price is hit.
The bottom line on the bid-ask spread
The bid-ask spread is the market’s way of managing supply and demand. Although primarily used to assist in the orderly trading of options, bid-ask spreads are also used by market managers to facilitate trading for securities that have low volume.
For a bid-ask spread to be successful, it requires both a buyer and a seller. Traders can help ensure their success with bid-ask spread by using limit orders that ensure they can walk away from a trade if it doesn’t meet specific price targets. Traders profit when investors execute market orders for a security without regard to the bid-ask spread because they are essentially confirming another trader's bid.
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