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Understanding the Bid Ask Spread and Its Cost

What is the Bid Ask Spread?

At any given time, the highest bid price offered for any stock is somewhat below the lowest ask price for which someone is willing to sell.

The bid and ask prices equalize momentarily during a trade but at all other times the ask exceeds the bid. This is referred to as the bid ask spread.

Highly liquid stocks which trade many shares per day and many times per day have bid ask spreads in the order of 10 cents or less which is only one half of one percent of the value of a $20.00 stock.

Thinly traded stocks can have huge bid ask spreads. Often this is the case for penny stocks. It is not particularly unusual for a stock that last traded at 30 cents to have a bid of 25 cents and an ask of 35 cents. In which case the bid  ask spread is 10 cents or a huge 33% of the last traded price.

Does the Bid Ask Spread Represent a Cost to Investors?

Yes, this bid ask spread constitutes a hidden cost when you trade stocks.

For example if a stock has a bid of $20 and an ask of $21, you would expect to lose $1.00 or 4.8% of your money if you bought at the ask of $21 and then immediately changed your mind and sold at the bid of $20. If you had bought 100 shares, you lose $100 on the bid ask spread. And this is in addition to the trading charges of perhaps $29 each way.

In this case you can see that the bid ask spread is significant. However, if this were a very liquid stock then the bid ask spread might only be 10 cents and then the loss would only be $10 and not very significant.

Who Receives the Bid Ask Spread Paid By Stock Traders?

In some cases there is a market maker who keeps an inventory of a particular stock and who makes a business of selling at the ask and buying at the bid. This  market maker posts bid and ask prices that are slightly narrower than the the market would post in his or her absence

The market maker hopes that buyers will raise their bids to his ask in order to a make a trade and that sellers will lower their price to his bid in order to make a trade. The market maker is at risk that the market will fall and he or she will lose money on their inventory.

Where there is not a market maker, the more reluctant trader or patient trader receives the bid ask spread at the expense of the more eager and impatient trader.

Can a Trader Avoid The Bid Ask Spread?

In practical terms, no.

In theory a trader can avoid the bid ask spread by being patient. If you want to buy, you can enter at the bid and hope the seller will come down to meet you. Similarly, when you sell you can enter at the ask offer and wait for buyers to raise their bids to come up to the offer.

But you take the risk that the market will move away from you and you will have to pay an even higher price to buy or a lower price to sell. Also when you enter a trade at the bid or ask, the traders that posted those prices are ahead of you in the trading queue.

When you have decided that you want a stock, you are probably expecting it to rise in price. Therefore it becomes risky to enter a limit order under the ask price. Similarly, if you want to sell because you fear a price drop, it is risky to enter a sell price above the current ask. In both cases if your expectation comes true, the market will move away from you.

Often when I have tried to get "cute" by entering a bid or offer that was off the market, I have regretted it as the market moved away from my bid or offer.

How Should the Bid Ask Spread Be handled?

For very liquid stocks that you want to trade, you should generally enter market orders. The bid ask spread is not particularly material in these cases.

If you are very ambivalent about buying or selling, then use a limit order that is off the market to avoid the bid ask spread and/or to buy or sell at a better price.

For thinly traded stocks be very cautious. The bid ask spread is often too high to ignore. The best course is to use limit orders at prices that you are comfortable with.

In general consider the bid ask spread to be part of your round trip trading costs. For this reason, stocks should usually not be traded in amounts under about $1500 since the trading charges and bid / ask spread become too large.

Be aware too, that the bid ask spread increases for large orders. For thinly traded stocks the increase with larger orders can be dramatic . This is affected by the depth of the market. In a shallow market the bids and offers are for small amounts of shares and larger amounts require higher buy prices and lower sell prices.

Shawn Allen, CMA, MBA, P.Eng.

InvestorsFriend Inc.

January 10, 2003

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