A bid-ask spread represents the difference between the highest price a buyer is willing to pay for a security (the bid) and the lowest price that a seller is willing to sell the security (the ask). Bid-ask spreads help determine the prices that investors can buy or sell securities.
What is bid-ask spread?
- Bid-ask spreads are the difference between the highest price a buyer is willing to pay (the bid) for a security and the lowest price a seller is willing to sell a security for (the ask).
- Bid-ask spreads are determined by market makers to compensate them for facilitating trades between investors.
- The degree of the spread is related to the security’s liquidity. The more liquid a security is, the smaller the bid-ask spread is.
Bid-ask spreads are how market makers--those who facilitate the transactions in the market--profit from their duties. Market makers (such as Goldman Sachs or Merrill Lynch) will purchase securities from investors at the lowest price they are willing to sell (the ask) and then turn around and sell that security at the highest price a buyer is willing to pay (the bid).
Liquidity plays a large part in determining the degree of the spread. If securities are illiquid or traded at a low volume, market makers will have a harder time finding buyers and sellers for that security. Therefore, the security will have a larger bid-ask spread to compensate for the risk of managing the trades of illiquid assets. Alternatively, securities that trade with consistently high volumes will have minimal bid-ask spreads. This allows the bid-ask spread to act as a marker of a security’s liquidity.