The Bid-Ask Spread

Dec 22, 2006 by

When you buy a stock, you might notice that there are two prices shown; the bid price and the ask price. The bid price is the price that you would get if you sold the stock, and the ask price is the price that you would pay if you bought the stock. The ask price is always higher than the bid price. The difference between the bid price and the ask price is known as “the bid-ask spread.” The bid-ask spread of an equity is higher the less it is traded. Options as well as stocks and ETFs have bid-ask spreads. In fact, if you try to buy a low-volume (rarely traded) option, you will find that its bid-ask spread is far higher than what you would find on a rapidly traded stock.

Why does the bid-ask spread exist? For one, it exists due to inefficiency in the market. Market makers sell stocks to buyers and buy stocks from sellers. While doing so, they can make money by lowballing the sellers and highballing the buyers. The more market makers there are for a given equity at a given point in time, the smaller the spread, as the extra competition makes prices more competitive (and closer to each other).

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  1. A bid-ask spread is not only common to stock. This tactic is used to glean payment for a number of financial services like currency exchange. There is always a difference between the US – Euro and Euro – US exchange rates because this is how a bank get reimbursed for its trouble. Some banks also charge a service fee but the spread is preferable because the fee scales with the money exchanged.

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