Bid-Ask Spread

A two-sided quote is the top of the limit order book: the best bid is the highest standing buy limit order, the best ask (or offer) the lowest standing sell limit order, each carrying a displayed size. The quoted spread is simply the ask less the bid, expressed in currency units. To compare across price levels, candidates convert it to a proportional figure by dividing the quoted spread by the midquote, where the midquote is the average of the bid and the ask. A stock quoted 49.98 bid, 50.02 ask has a two-cent spread on a 50.00 midquote, or four basis points.

Depth matters as much as width. The quoted spread applies only to the displayed size; an order larger than that must consume successive price levels, so the realised cost exceeds the top-of-book quote. This is why the effective spread, defined as twice the absolute difference between the execution price and the midquote prevailing when the order arrived, is the more honest measure of what immediacy actually cost.

Spread width is not arbitrary. It compensates the liquidity supplier for three distinct exposures. Order processing costs cover technology, exchange fees, clearing and the operational burden of standing ready to trade. Inventory risk arises because a dealer who absorbs one side of the market holds an unwanted position whose value can move before it is unwound; the greater the volatility and the longer the expected holding period, the wider the quote. Adverse selection risk is the most subtle: some counterparties trade because they know something the dealer does not, and the dealer loses systematically to them. Wider quotes recover those losses from uninformed flow.

The observable determinants follow directly. High volume, large capitalisation, many competing market makers, transparent order flow and small tick sizes all compress spreads. Thin trading, high volatility, opaque markets and concentrated dealer power widen them.

In order-driven electronic equity markets the spread is visible and continuously updated, and any participant can supply liquidity by posting a limit order rather than paying the spread with a market order. In quote-driven over-the-counter markets, particularly corporate and municipal bonds, dealers quote bilaterally, spreads are far wider, and the cost is embedded in the price rather than itemised, which makes it easy to underestimate.

Exchange-traded funds illustrate the mechanism cleanly. An ETF's spread reflects the cost of hedging or creating and redeeming the underlying basket, so a fund tracking large-cap domestic equities may trade a penny wide while one holding emerging-market debt trades far wider, even with identical share prices. Spreads also widen predictably at the open, before the close, around scheduled announcements and whenever underlying markets are shut.

Be able to compute the quoted spread, express it as a percentage of the midquote, and calculate the effective spread from a fill price and the arrival midquote. Understand that the half-spread is the one-way cost and the full spread approximates the round-trip cost of demanding immediacy in both directions, before commissions and any market impact from working a large order.

Be able to reason about order choice: a market order guarantees execution and pays the spread; a limit order posted inside or at the quote supplies liquidity, may earn the spread, but risks non-execution and adverse selection. Finally, treat the spread as a liquidity metric alongside depth, turnover and resilience, and recognise its consequence for strategy design, since high-turnover approaches in illiquid names can see gross alpha consumed entirely by implicit trading costs.