What it means
Every quoted market shows two prices rather than one. If a share is quoted at 24.60 bid and 24.75 ask, you can sell right now at $24.60 or buy right now at $24.75.
The single price shown on a news site is usually the last traded price or the midpoint, and neither is what you would actually receive or pay. The spread exists because somebody has to stand ready to trade with you at any moment.
Market makers quote both sides and earn the difference in return for taking on the risk of holding stock that might move against them before they can offload it. The greater that risk, the wider the quote.
Liquidity is the main driver. Heavily traded shares and major currencies trade at very tight spreads, while a small company's shares, an obscure bond or a piece of commercial property can show spreads of several percentage points.
Volatility widens them further, which is why quotes gap out around results announcements and market shocks. The spread is a real and frequently overlooked cost.
A fund that trades often pays it on every round trip, and for a private investor buying a small company's shares it can easily exceed the broker's commission. Comparing the midpoint you saw on screen with the price you actually got is the quickest way to see what it cost you.
The same language appears well outside share markets. Foreign exchange desks, bond traders, used equipment dealers and business brokers all quote a buying price and a selling price, and the logic is identical: the spread pays whoever is willing to take the other side and carry the inventory.
In practice
Real-world examples.
Example
A currency desk quotes a business 1.2740 bid and 1.2744 ask on a euro payment. On a $2,000,000 conversion the four-point spread costs the business roughly $630, which the treasurer negotiates down by dealing in a single block rather than in small tranches.
Example
An investor tries to sell 40,000 shares in a small listed engineering company where the bid is only good for 5,000 shares. Selling the whole holding pushes the price down through successive levels, and the average price achieved is well below the quoted bid.
Example
A used machinery dealer offers a bakery $34,000 for a second-hand oven and lists the same model for sale at $41,000. The $7,000 spread covers refurbishment, storage, warranty risk and profit, and is the dealer's core business model.
Formula
Calculation
Spread = Ask Price - Bid Price
Mid Price = (Bid Price + Ask Price) / 2
Spread as a percentage = (Spread / Mid Price) x 100
Worked example. A mid-sized listed company's shares are quoted at $24.60 bid and $24.75 ask.
Spread = $24.75 - $24.60 = $0.15
Mid Price = ($24.60 + $24.75) / 2 = $24.675
Spread as a percentage = ($0.15 / $24.675) x 100 = 0.61%
An investor buying 10,000 shares pays 10,000 x $24.75 = $247,500. If they changed their mind a second later and sold at the bid, they would receive 10,000 x $24.60 = $246,000. The $1,500 difference is pure cost of crossing the spread, before any broker commission, and it is why frequent trading in less liquid shares is so expensive.Case study
Seen in the real world.
Vantage Ridge Fund is a fictional small-company equity fund used here as an illustrative example of hidden trading costs. Its published performance had trailed a comparable index by about 1.8% a year for three years, and the manager could not explain the gap from stock selection alone.
An operational review measured the average spread on the shares the fund traded, which came to 1.4% of the midpoint, and the fund's annual portfolio turnover, which was 130%. Multiplying those together showed that crossing the spread alone was costing the fund a little under 2% of assets each year, before commissions. The performance gap was not a selection problem at all.
Vantage Ridge responded by cutting turnover to 45%, using limit orders sitting inside the spread rather than market orders, and breaking large trades into smaller pieces over several days. The illustrative point is that the spread is a cost like any other, and in less liquid markets it can quietly overwhelm the returns a strategy is designed to produce.
Watch out
Common mistakes.
- Valuing a holding at the ask price when you would only ever receive the bid price on sale.
- Assuming the quoted spread applies to any size of trade, when large orders often have to move through several price levels.
- Comparing broker commissions carefully while ignoring the spread, which is frequently the larger of the two costs.
Questions
People also ask.
Why is the ask always higher than the bid?
Because whoever stands ready to trade with you on demand needs compensating for the risk and the capital tied up in holding the asset.
Does a wide spread mean an asset is a bad investment?
Not necessarily, but it does mean the asset is expensive to trade, so it suits a long holding period rather than frequent dealing.
Which price do I get when I place a market order?
You buy at the ask and sell at the bid, which is why a market order to buy and then immediately sell always shows an instant loss.
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