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Bid-Ask Spread

If you're investing in individual securities, particularly less-liquid ones, it pays to be aware of bid-ask spreads when you're buying and selling. The bid is the price that someone is willing to pay for a security at a specific point in time, whereas the ask is the price at which someone is willing to sell. The difference between the two prices is called the bid-ask spread.

Bid-ask spreads have the characteristic of heads they win, tails you lose: If you're a seller, you receive the lower price (the bid), and if you're a buyer, you pay the higher price (the ask). (Note that bid-ask spreads aren't an issue for mutual fund buyers and sellers, at least not directly, because the fund is priced just once a day, and everyone pays and receives that same price.)

If you're trading highly liquid securities, the bid-ask spread will tend to be pretty inconsequential, meaning that buyers and sellers generally agree about what the right price for a security should be. For example, the bid-ask spread for the exchange-traded fund SPDR S&P 500 (SPY), which is itself dominated by heavily traded, household-name companies such as Microsoft (MSFT) and Johnson & Johnson (JNJ), is often just a penny or two.

But bid-ask spreads can be more onerous when you're dealing in more thinly traded securities, such as small-company stocks or ETFs with light trading volume. The bid-ask spread compensates the market maker in the security (which matches buyers with sellers) in case it can't find buyers for the shares and the price moves around a lot before it does. The greater the risk of that happening, the more the market maker demands in terms of a bid-ask spread. Think of the bid-ask spread as the markup on your purchase or sale.

So how can you reduce the drag of bid-ask spreads on your returns? At the risk of stating the obvious, reducing your number of transactions is a good starting point, particularly if you're dealing in any type of illiquid security. Another way to exert more control is to use a limit order rather than a market order. By doing so, you're saying that you're not going to accept any old price when buying and selling (a market order); you only want to transact if you can get a specific price or better.

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