What it means
Market makers quote both sides of a price and earn the spread as compensation for standing ready to trade. They carry the risk that prices move against the inventory they are holding, and the spread is the price of that service.
Nobody sends an invoice for it, which is why it is easy to overlook as a cost. Three things drive how wide a spread is.
Trading volume comes first, since heavily traded assets attract many competing quotes; volatility comes second, because a market maker facing sudden price swings needs a bigger cushion; and the size of the trade comes third, as large orders are harder to offload. A blue-chip share might trade on a spread of a few hundredths of a percent while a rarely traded corporate bond can show several percent.
For businesses and investors the spread is a drag on returns that compounds with activity. A strategy trading in and out weekly pays the spread every round trip, so a 0.4% spread traded fifty times a year consumes 20% of capital before any market movement is considered.
This is one reason frequent trading struggles to beat a simple buy-and-hold approach. The spread also functions as a health indicator for a market.
When spreads widen sharply across many assets at once, it usually means market makers are pulling back because they cannot judge fair value, and that often precedes or accompanies a sharp price move. Regulators and exchange operators watch aggregate spreads for exactly this reason.
One common variant is the effective spread, which measures the difference between the price actually paid and the midpoint at the time of the order. It is often narrower than the quoted spread because some orders execute inside the quote, and it is the fairer measure of what trading really cost.
In practice
Real-world examples.
Example
A wealth manager comparing two exchange traded funds tracking the same index finds one quotes a spread of 0.05% and the other 0.35%. For a client trading quarterly, the cheaper fund saves roughly 1.2% a year in dealing costs even though the headline management fees are identical.
Example
A corporate finance team selling a block of unlisted preference shares receives indicative bids 8% below the asking prices circulating among brokers. The wide spread reflects how rarely the instrument trades, and the sale is restructured as a negotiated private deal instead.
Example
During a sharp market fall, a day trader finds that spreads on mid-cap shares have widened from 0.1% to 0.9%. The strategy's expected profit per trade was only 0.5%, so trading is suspended until spreads normalise.
Think of it
“Bid-ask spread is the gap between buying and selling prices-your transaction cost for trading.
Formula
Calculation
Bid-ask spread = Ask price - Bid price, and Spread percentage = (Ask - Bid) / Midpoint x 100
A listed retailer's shares are quoted at a bid of $49.90 and an ask of $50.10. The absolute spread is $50.10 - $49.90 = $0.20, the midpoint is ($50.10 + $49.90) / 2 = $50.00, and the spread percentage is $0.20 / $50.00 x 100 = 0.4%.
An investor buying 2,000 shares pays 2,000 x $50.10 = $100,200. Selling them back immediately at the bid returns 2,000 x $49.90 = $99,800, so the round trip costs $100,200 - $99,800 = $400, exactly 2,000 x $0.20. The share price has to rise by 0.4% just for the investor to break even before any commission.Case study
Seen in the real world.
The following is an illustrative and fictional case. Pellworth Asset Management, an invented firm running a tactical equity fund, reported a strategy that looked strong on paper, with backtested gross returns of 14% a year based on closing mid prices. The fund launched with $60,000,000 under management.
Live returns came in at just under 6%. A review found the strategy turned over the portfolio roughly forty times a year, and the average round-trip spread on the mid-cap shares it favoured was about 0.2%, which quietly removed around 8% of value annually. None of this had appeared in the backtest, which had assumed trades executed at the midpoint.
The fictional firm rebuilt its testing to charge the full quoted spread on every simulated trade, and the strategy's modelled return dropped below its benchmark. Pellworth reduced turnover to about eight trades a year and refocused on larger, more liquid shares, after which live and modelled returns finally tracked each other.
Watch out
Common mistakes.
- Treating commission as the only cost of trading and ignoring the spread, which is frequently the larger of the two.
- Backtesting a trading strategy at midpoint prices, which flatters results for anything that trades often.
- Assuming a low-fee product is cheap without checking its spread, since a wide spread can easily outweigh a small fee difference.
Questions
People also ask.
Why do market makers deserve the spread?
They commit capital to quote continuously in both directions and absorb the risk of holding inventory when prices move, so the spread is payment for providing that immediacy.
Does the spread affect long-term investors?
Much less than active traders, because a one-off 0.4% cost spread over a ten-year holding period works out at roughly 0.04% a year.
Can you trade inside the spread?
Sometimes, by placing a limit order between the bid and ask and waiting; the trade-off is that it may never be filled.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%