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
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
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
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
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
Shawn Allen, CMA, MBA, P.Eng.
January 10, 2003