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The bid–ask spread (also bid–offer or bid/ask and buy/sell in the case of a
market maker A market maker or liquidity provider is a company or an individual that quotes both a buy and a sell price in a tradable asset held in inventory, hoping to make a profit on the difference, which is called the ''bid–ask spread'' or ''turn.'' Thi ...
) is the difference between the prices quoted (either by a single
market maker A market maker or liquidity provider is a company or an individual that quotes both a buy and a sell price in a tradable asset held in inventory, hoping to make a profit on the difference, which is called the ''bid–ask spread'' or ''turn.'' Thi ...
or in a limit order book) for an immediate sale ( ask) and an immediate purchase ( bid) for
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,
futures contract In finance, a futures contract (sometimes called futures) is a standardized legal contract to buy or sell something at a predetermined price for delivery at a specified time in the future, between parties not yet known to each other. The item tr ...
s, options, or currency pairs in some auction scenario. The size of the bid–ask spread in a security is one measure of the liquidity of the market and of the size of the
transaction cost In economics, a transaction cost is a cost incurred when making an economic trade when participating in a market. The idea that transactions form the basis of economic thinking was introduced by the institutional economist John R. Commons in 1 ...
. If the spread is 0 then it is a frictionless asset.


Liquidity

The trader initiating the transaction is said to demand
liquidity Liquidity is a concept in economics involving the convertibility of assets and obligations. It can include: * Market liquidity In business, economics or investment, market liquidity is a market's feature whereby an individual or firm can quic ...
, and the other party (
counterparty A counterparty (sometimes contraparty) is a Juristic person, legal entity, unincorporated entity, or collection of entities to which an exposure of financial risk may exist. The word became widely used in the 1980s, particularly at the time of the ...
) to the transaction supplies liquidity. Liquidity demanders place market orders and liquidity suppliers place
limit order An order is an instruction to buy or sell on a trading venue such as a stock market, bond market, commodity market, financial derivative market or cryptocurrency exchange. These instructions can be simple or complicated, and can be sent to e ...
s. For a round trip (a purchase and sale together) the liquidity demander pays the spread and the liquidity supplier earns the spread. All limit orders outstanding at a given time (i.e. limit orders that have not been executed) are together called the Limit Order Book. In some markets such as
NASDAQ The Nasdaq Stock Market (; National Association of Securities Dealers Automated Quotations) is an American stock exchange based in New York City. It is the most active stock trading venue in the U.S. by volume, and ranked second on the list ...
, dealers supply liquidity. However, on most exchanges, such as the
Australian Securities Exchange Australian Securities Exchange Ltd (ASX) is an Australian public company that operates Australia's primary Exchange (organized market), securities exchange, the Australian Securities Exchange (sometimes referred to outside of Australia as, or c ...
, there are no designated liquidity suppliers, and liquidity is supplied by other traders. On these exchanges, and even on NASDAQ, institutions and individuals can supply liquidity by placing limit orders. The bid–ask spread is an accepted measure of liquidity costs in exchange traded securities and commodities. On any standardized exchange, two elements comprise almost all of the
transaction cost In economics, a transaction cost is a cost incurred when making an economic trade when participating in a market. The idea that transactions form the basis of economic thinking was introduced by the institutional economist John R. Commons in 1 ...
—brokerage fees and bid–ask spreads. Under competitive conditions, the bid–ask spread measures the cost of making transactions without delay. The difference in price paid by an urgent buyer and received by an urgent seller is the liquidity cost. Since brokerage commissions do not vary with the time taken to complete a transaction, differences in bid–ask spread indicate differences in the liquidity cost.


Types of spreads


Quoted spread

The simplest type of bid-ask spread is the quoted spread. This spread is taken directly from quotes, that is, posted prices. Using quotes, this spread is the difference between the lowest asking price (the lowest price at which someone will sell) and the highest bid price (the highest price at which someone will buy). This spread is often expressed as a percent of the midpoint, that is, the average between the lowest ask and highest bid: \text = \frac\times100.


Effective spread

Quoted spreads often over-state the spreads finally paid by traders, due to "price improvement", that is, a dealer offering a better price than the quotes, also known as "trading inside the spread". Effective spreads account for this issue by using trade prices, and are typically defined as: \text = 2 \times \frac\times 100. The effective spread is more difficult to measure than the quoted spread, since one needs to match trades with quotes and account for reporting delays (at least pre-electronic trading). Moreover, this definition embeds the assumption that trades above the midpoint are buys and trades below the midpoint are sales.


Realized spread

Quoted and effective spreads represent costs incurred by traders. This cost includes both a cost of asymmetric information, that is, a loss to traders that are more informed, as well as a cost of immediacy, that is, a cost for having a trade being executed by an intermediary. The realized spread isolates the cost of immediacy, also known as the "real cost". This spread is defined as: \text_k = 2 \times \frac\times 100 where the subscript k represents the kth trade. The intuition for why this spread measures the cost of immediacy is that, after each trade, the dealer adjusts quotes to reflect the information in the trade (and inventory effects). Inner price moves are moves of the bid-ask price where the spread has been deducted.


Examples


Currency spread

If the current bid price for the EUR/USD currency pair is 1.5760 and the current offer price is 1.5763, this means that currently you can sell the EUR/USD at 1.5760 and buy at 1.5763. The difference between those prices (3 pips) is the spread. If the USD/JPY currency pair is currently trading at 101.89/101.92, that is another way of saying that the bid for the USD/JPY is 101.89 and the offer is 101.92. This means that currently, holders of USD can sell US$1 for 101.89 JPY and investors who wish to buy dollars can do so at a cost of 101.92 JPY per US$1.


Metals

Gold and silver are known for having the tightest bid-ask spreads, making them useful as
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, while other metals may have wider bid-ask spreads due to lower trading volumes, less liquidity, or large fluctuations in supply and demand. For example, rare metals like platinum, palladium, and rhodium have lower trading volumes compared to gold or silver, which can result in larger bid-ask spreads.


See also

* Bid–ask matrix * Demand and offer *
Market maker A market maker or liquidity provider is a company or an individual that quotes both a buy and a sell price in a tradable asset held in inventory, hoping to make a profit on the difference, which is called the ''bid–ask spread'' or ''turn.'' Thi ...
* Mid price *
Price elasticity of demand A good's price elasticity of demand (E_d, PED) is a measure of how sensitive the quantity demanded is to its price. When the price rises, quantity demanded falls for almost any good ( law of demand), but it falls more for some than for others. Th ...
*
Spot price In finance, a spot contract, spot transaction, or simply spot, is a contract of buying or selling a commodity, security or currency for immediate settlement (payment and delivery) on the spot date, which is normally two business days after t ...
*
Underwriting spread The underwriting spread is the difference between the amount paid by the underwriting group in a new issue of securities and the price at which securities are offered for sale to the public. It is the underwriter's gross profit margin, usually expr ...


References


Further reading

# {{DEFAULTSORT:Bid-ask spread Financial markets