Why Understanding The Bid-Ask Spread Matters in Your Stock Investing

You may hear of the term “spread”, or “bid-ask spread”, but you may not know how it relates to your stock trading. The bid-ask spread is the principal transactional cost and thus can affect the overall return of your investments.

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Definition: Bid, Ask, Spead

Bid: the highest price that buyers are willing to pay for an asset

Ask: the lowest price that sellers are willing to accept for the same asset

Bid-Ask Spread: the difference between the bid price and the ask price when trading the asset

An Example of A Bid-Ask Spread in Stocks

When investing in the UK stock market, if the bid price for a stock is £50 and the ask price is £51, then the bid-ask spread for the stock is £1. The spread can also be expressed in percentage terms, which in this case would be 2% (£1 / £50 x 100).

So, to calculate the bid-ask spread in percentage is quite straightforward. Simply use this formula:

(Ask – Bid) / Ask x 100

What Kind of Information A Bid-Ask Spread Tells

The bid-ask spread indicates the supply (bid) and demand (ask) for a particular asset.

For the stock in the example above, if a potential buyer offered to purchase the stock at a higher price or if a potential seller offered to sell the stock at a lower price, the bid-ask price would close. So assets with a tight bid-ask spread are typically highly liquid. Big names, such as Amazon, Apple and Tesla, have narrow spreads because there is a high amount of supply and demand for their shares.

A wide bid-ask spread can suggest just the opposite. When there aren’t high levels of supply and demand, the spread widens. You’ll typically see a wider bid-ask spread for small-cap or penny stocks.

Mitigate Your Spread Cost

The bid-ask spread is collected by the market maker when processing orders at the bid and ask prices. Although it might appear insignificant or easy to overlook, the spread is an actual cost for investors. In certain scenarios, it can constitute a significant portion of the trade’s value. Consequently, an active trader in particular may need to pay more attention to the spread.

To avoid high spread costs, you can trade stocks with high liquidity during active market hours. Setting limit orders also allows you to choose the price you’re willing to buy or sell at.