Understanding Bid-Ask Spreads

Every security traded on a financial exchange has two prices at any given moment: the bid and the ask (sometimes called the offer). The bid price is the highest price any buyer is currently willing to pay for the security. The ask price is the lowest price any seller is currently willing to accept.

When you want to buy a security immediately, you pay the ask price — you are accepting the seller's terms. When you want to sell a security immediately, you receive the bid price — you are accepting the buyer's terms. The last traded price (shown on most price displays) is the price at which the most recent transaction occurred, which is always somewhere between or equal to the bid and ask at that moment.

The bid-ask spread is simply the difference between these two prices. If a stock has a bid of $49.98 and an ask of $50.02, the spread is $0.04. If a stock has a bid of $10.00 and an ask of $10.50, the spread is $0.50. Spreads can be expressed in dollar terms (as above) or as a percentage of the mid-price (the average of bid and ask).

The bid-ask spread represents compensation for market makers — firms and individuals who continuously provide liquidity to the market by standing ready to buy at the bid and sell at the ask. Market makers profit from the spread: they buy at the bid, sell at the ask, and pocket the difference on each completed round-trip.

Market makers take on inventory risk by holding positions in securities. If they buy shares at the bid and the price falls before they can sell at the ask, they lose money. The spread is compensation for this risk — the wider the spread, the more cushion the market maker has against adverse price moves before the position can be unwound.

In modern electronic markets, market making is highly competitive and largely automated. Many firms simultaneously provide bids and asks across thousands of securities, and competition among them tends to narrow spreads. This is why spreads on major stocks are often just one or two cents — competition has compressed the market maker's margin to a very thin amount.

Liquidity is the primary driver of spread width. Highly liquid securities — those with large numbers of buyers and sellers and high trading volume — tend to have narrow spreads. Major US large-cap stocks (Apple, Microsoft, Alphabet), index ETFs (SPY, QQQ), and major currency pairs (EUR/USD, GBP/USD) often have spreads of one cent or less during regular trading hours.

Less liquid securities have wider spreads. Small-cap stocks, thinly traded ETFs, and securities in emerging markets may have spreads of $0.10, $0.50, or even several dollars. For very thinly traded stocks, the spread might be 5–10% of the stock's price — an immediate cost that must be overcome before the trade can be profitable.

Volatility also affects spreads. During periods of high uncertainty — around major economic data releases, earnings announcements, or market-wide stress events — market makers widen their spreads to compensate for the increased inventory risk they are taking on. You may notice spreads on even major stocks widening noticeably in the seconds around a scheduled Federal Reserve announcement.

Time of day matters too. Pre-market and after-hours trading sessions have fewer participants and therefore wider spreads than the regular session. The first few minutes after the market opens can also have temporarily wider spreads as the market establishes the day's price level.

The bid-ask spread is an implicit transaction cost — it is not a fee charged by a broker (like a commission), but it reduces the value you receive on every trade. Every time you buy at the ask and later sell at the bid, you pay the spread twice — once on entry and once on exit.

Consider a stock with a bid of $99.95 and an ask of $100.05 (a $0.10 spread). If you buy at $100.05 and the price does not move, you immediately hold shares worth $99.95 (the price at which you could sell them). You have lost $0.10 per share to the spread before the trade has even had a chance to move in your favour.

For long-term investors who trade infrequently, the spread cost on a major stock is negligible relative to the investment horizon. For active traders who enter and exit positions frequently — particularly day traders — the cumulative cost of spreads across dozens or hundreds of trades can be significant and must be accounted for in any assessment of a strategy's profitability.

One way traders manage spread costs is by using limit orders to join the bid or ask rather than immediately crossing the spread. Instead of placing a buy market order (which executes immediately at the ask), a trader places a buy limit order at the current bid price. If the price comes down to their bid, they are filled at a better price — they have 'made the spread' rather than 'paid the spread.'

This approach has a trade-off: the limit order may not fill. If the price moves up instead of down, the order is left unfilled and the trader misses the trade. The decision between paying the spread for certainty of execution versus attempting to avoid it with a limit order depends on how urgently the trader needs to execute and how much the spread matters relative to the expected move.

Market makers and high-frequency traders are continuously placing orders at or near the bid and ask, earning the spread on each transaction. Retail traders generally cannot compete in this space, but understanding how the spread works helps in making more informed decisions about when and how to use each order type.

Most trading platforms display the bid and ask prices prominently alongside the last traded price. The Level 1 quote shows only the best bid and best ask (the tightest available spread). A Level 2 quote (available through many brokers) shows the full depth of the order book — all the bids and asks at different price levels, showing how much volume is available at each price.

When evaluating a trade in a less liquid security, looking at Level 2 data before placing an order can be informative. A wide spread between the best bid and best ask, or very thin volume at the best prices, suggests that a large market order could move the price significantly before filling completely — a form of market impact that compounds the explicit cost of the spread.

This article is for educational purposes only and does not constitute financial or investment advice. All trading involves risk, including the risk of loss. Always conduct your own research and due diligence before making any trading or investment decisions.