The Relevance of the Bid-Ask Spread to Traders

The bid ask spread is the difference between the bid price and ask price of a stock.  In most high volume US stocks, the spread is normally just 1 penny, meaning the offer price is one cent higher than the bid.  This is the lowest denomination that can be published on the book of a stock, although in dark pools transactions may occur at fractions of a penny so the spreads here are effectively smaller at times.  Even though in many high volume securities the spread is one penny, it is not required or mandated to be so small.  In fact there are many instances where we may see larger spreads, and traders should be aware of why they may differ and change.

Although high volume low price stocks will normally have the smallest spreads, many popular US stocks regularly trade with spreads of larger than one penny.  These are the factors  most likely to affect the spread in a stock.

  • Price of stock
  • Volume of stock
  • Volatility of stock
  • Market maker activity

These factors are not necessarily in order of importance, although designated market makers of course have the obligation to facilitate orderly trading activities and keeping spreads reasonably tight is a big part of maintaining order.   This means that market makers effectively can keep a spread as tight as they wish (up to one penny) although large orders or extreme volatility (such as in the flash crash) may overwhelm even the market makers.

Generally speaking as a stock price rises, the spread will widen.  This is intuitive since the higher price may effectively cancel out the spread widening on a percentage basis.  IE if a $10 stock has a 1 penny spread the spread is the same on a percentage basis as a $100 stock with a 10 penny spread.  Also because the stock is more expensive per share, there is generally less shares posted on the books than a lower priced security.

Volume will affect the spread in the same way.  If there are fewer shares transacting, there is a higher likelihood that there will not be shares posted on each penny increment on the books and wider spreads are generally seen.

Higher volatility can create wider spre  If a stock is very volatile, its fair value at any one point in time is generally less agreed on by the market as a whole.  This means that all of the buy/sell interest will not be tightly centered around the last transaction price, and wider spreads are seen.

Spreads are very pertinent to high frequency traders, especially algorithmic traders.  This is because often times their entire profit goal is simply the spread.  A higher spread may generate higher profits per round lot traded for them, but it also may imply greater risk that they will not be able to exit their positions at their desired price.  It should be noted that with the rise of high frequency traders, spreads have generally become tighter as they seek to profit from smaller and smaller inefficiencies as well as add volume to the system.

All traders must be concerned with what a spread implies about the liquidity of a security.  If a trader purchases a position at the ask, which is $1 higher than the bid, the only way the trader could exit the position instantly is by selling to the bid, and assuming the loss.  In especially illiquid securities, a trader should never assume that they will be able to exit the position with a limit order at the bid or ask.  A high spread could imply the possibility of difficulty exiting the position at the desired price.

Hand traders who are scalpers are especially concerned with spreads since a wide spread may make scalping very difficult, especially during volatile trading times.

All traders should be aware though of factors that are influencing spreads, and if a trader spots a changing spread it may be useful to ask why the spread is changing and what it may mean for their trade.

 

Daniel Major

B.S. Degree in Economics and Finance. Professional day trader. Live and work in Manhattan, NY, NY.

Page Updated: September 16, 2013

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