The financial markets can be confusing for those unfamiliar with their terminology. One of the concepts that you surely need to understand is the bid-ask spread, which plays a critical role in determining the price of assets. In this guide, we share the bid-ask spread definition and explain why every investor and trader should know it.
What Is A Bid-Ask Spread?
The bid-ask spread, also known as the bid-offer spread, is the difference between the highest price a buyer is willing to pay (bid price) and the lowest price a seller is willing to accept (ask price) for a particular security or asset.
For example, let’s say that a stock has a bid price of $100 and an ask price of $102. This means that a buyer is willing to purchase the stock for $102, and a seller will sell it for no less than $100. The bid-ask spread, in this case, equals $2.
What You Need To Know About The Bid-Ask Spread
The bid-ask spread is a crucial component of market liquidity. A smaller spread indicates that there is a more active market with plenty of buyers and sellers willing to trade at similar prices. A larger spread, on the other hand, means that the market is less liquid, which makes it harder to execute trades at a favorable price.
Understanding the bid-ask spread concept is crucial for investors and traders because it can affect the profitability of their trades.
For instance, if an investor buys a stock at the ask price and then immediately sells it at the bid price, they will incur a loss equal to the bid-ask spread. Therefore, the wider the spread, the more significant the loss.
Moreover, the bid-ask spread can also affect the accuracy of market orders. Suppose an investor wants to purchase a stock at the current market price, which is determined by the ask price. If the bid-ask spread is wide, the investor may end up paying more than they intended because the actual price may be closer to the bid price.
