Bid ask spread

The bid ask spread in probably one of the most important concepts in finance, especially for active day traders and liquidity providers. The bid ask spread indicates the liquidity in a certain stock, currency bond. The larger the spread is, the more illiquid and thus the more costly it is to trade. Additionally, large spread securities may also be more difficult to offload in the future, as nobody could be willing to provide liquidity at an adequate price. Small spread on the other hand indicate great liquidity in a security. These securities are easy and fast to trade, at low-cost. Passive investors can avod paying the spread and thus improving their return simply by submitting a limit buy or sell order.

Limit orders

On many markets, bid ask spreads are the result of market participants submitting limit orders to an electronic platform. Some of them want to sell, other want to buy. These markets participants therefore jointly construct a limit order book. More specifically, a limit order book is just a record at which price participants are willing to buy and sell and for which amount.

Bid side

The bid side of the order book indicates the prices at which certain market players are willing to buy a certain share or other security. Next to this, the quantity they are willing to buy are attached next to each order. The more bid limit orders are given in, the greater the depth at the bid side. This means that a submitted aggressive large sale is more likely being completely settled since there’s a sufficient supply on the bid (buy side).

Ask side

The ask side of the order book indicates the prices at which certain market players are willing to sell a certain share or other security. Next to this, the quantity they are willing to sell are attached next to each order. The more ask limit orders are given in, the greater the depth at the ask side. This means that a submitted aggressive large buy order is more likely being completely settled since there’s a sufficient supply on the ask (sell side).

Bid ask spread explained

The bid ask spread is just the difference between the best ask price and the best bid price. Depending on the security and the time of day and the uncertainty spreads can be large or rather small. For an active traders using market orders, larger spreads deteriorate the profitability of applied strategies. On the other hand, larger spreads make liquidity providing strategies more attractive. Therefore, submitting limit buy and sell orders in the hope of earning on this spread through the execution of many trades on both sides becomes more attractive.

Summary

The bid ask spread is the difference between the best (lowest) price at which someone is willing to sell and the best (highest) price at which someone is willing the buy a certain security. The larger the bid ask spread the more costly it is to make a transaction and the more illiquid the security is. Transaction costs due to the bid ask spread can be easily avoided simply by submitting limit orders, although it should be noted that it is not certain that a transaction will take place at the limit price.

FACEBOOK
TWITTER
GOOGLE
http://breakingdownfinance.com/trading-strategies/passive-investing/bid-ask-spread">