Know more about bid-ask spreads and its significance
Ever wondered why you are not able to buy or sell a stock at precisely the last traded price that you saw on the exchange? It is because of the bid-ask spread!
A ‘bid’ is the highest price at which a buyer is willing to buy a particular asset and ‘ask’ is the lowest price at which a seller is willing to sell a particular asset while the difference between the two is called ‘spread’ and hence, the term - bid-ask spread.
How does it work?
In any market, there are buyers and sellers. However, their number has an influence on the bid-ask spread. Let us look at the table below and assume that a stock ‘ABC’ is trading at Rs 100.
|
Bid
|
Ask
|
|
Price
|
Quantity
|
Price
|
Quantity
|
|
99
|
20
|
101
|
50
|
|
98
|
70
|
102
|
30
|
|
97
|
10
|
103
|
20
|
Traders, who post bids, are called market makers while traders, who trade with them, are called market takers. If someone posts a bid of 99.5, higher than the already highest bid, then, that is known as making a new market. If any trader wants to aggressively sell 100 quantities at market order, the bid prices will get fulfilled and the price of the asset will fall to 97. However, in real-time equity markets, there are a huge number of buyers & sellers and thus, the prices fluctuate continuously.
What affects the spread?
The bid-ask spread is primarily affected by the liquidity in a particular asset market. For the currency market, which is considered as the most liquid asset, the spreads are minimum, especially for highly liquid currencies like Dollar, Euro, INR, etc. However, if a trader wants to sell Mexican Pesos for Indonesian Rupee, it is not going to be a smooth trade due to liquidity and hence, the spreads are higher. Lower spreads tell you how liquid the markets are. In the case of equities, for large-cap stocks, the spreads are usually lower, since they are highly-traded stocks but in the case of small-caps, we can see spreads of 1 per cent or sometimes, 2 per cent.
As an investor, the bid-ask spread can be a useful tool to gauge the liquidity in an asset class. Also, before trading particular security, an investor needs to decide what kind of order - a market order or limit order, he/she wants to place based on the spreads.