Every single day when the market opens, a battle between buyers and sellers begins and the prices of securities start moving. It can really pay off to review the basic economic concept of supply and demand before you start trading or investing. That being said, many new traders and investors struggle to fully comprehend how this economic concept applies to the financial markets.
That’s why it’s so important for investors to spend some time learning basic stock market terminology before diving in headfirst. The term “bid-ask spread” is the perfect example of something that is absolutely essential for traders and investors to understand. There are plenty of people that have probably heard of the bid-ask spread, but many do not know what it really means. That’s why we are going to take a deeper look at the bid-ask spreads below.
Bid-Ask Spreads Defined
Every day after the opening bell sounds, buyers and sellers start sending in their orders. These buyers and sellers determine the price of a stock or security based on the maximum amount they are willing to pay for a security or the minimum amount that they are willing to receive for selling a security. Buyers that are looking to purchase a security will state how much they are willing to pay with a bid price. Sellers that are interested in offloading their securities state the minimum amount that they are willing to sell for with an ask price.
Therefore, the bid-ask spread is basically the difference between the highest price that someone is willing to pay for a security and the lowest price that someone is willing to sell a security for. The difference between the bid and the ask, or the spread, can be considered the cost of the transaction. This transaction cost normally goes to the broker that helps buyers and sellers execute their orders. It’s always very important to look at the bid-ask spread before buying or selling a financial asset.
As shares of a stock or security change hands throughout the day, the bid-ask spread is constantly changing as well. It’s definitely worth noting that the bid price and the ask price are never the same. If you look at the bid-ask spreads for several different securities, you will notice that the ask price is always higher than the bid price. If you want to buy a security with a market order, you will receive the bid price while selling a security with a market order will provide you with the ask price. Keep in mind that if you aren’t willing to accept receiving either the bid price or the ask price, you can use limit orders to guarantee that your trade will only execute at your limit price or better.
Why is the Bid-Ask Spread Important?
The bid ask-spread is important to understand because it helps investors and traders follow the market prices of securities.
The spread can also tell you a lot about a security if you know what to look out for. For example, you can learn whether or not a specific security has liquidity based on the bid-ask spread. If you notice that the bid and the ask prices are very far apart, it usually means that the security does not have a lot of liquidity. On the flip side, if you see that the bid and the ask price of a security are very close together, the security likely has more liquidity. You can also view the bid-ask spread as a direct reflection of the supply and demand for a specific security. If a stock or security is in high demand on the market, the bid-ask spread will be narrower. Lastly, you can normally learn whether or not a security is volatile by its bid-ask spread. Note that more volatile securities tend to have larger spreads.
The Bottom Line
If you want to be successful with trading securities and investing, understanding the bid-ask spread is vital. It will help you determine the supply and demand for a security, figure out what the market is pricing it at, and let you know a little about how liquid or illiquid a security is. Your goal is to buy and sell securities at the best possible prices, which is why a firm understanding of the spread can really pay off in the long run.