Bid-offer spread
Encyclopedia
The bid–offer spread for securities
(such as stocks, futures contract
s, options
, or currency pair
s) is the difference between the prices quoted (either by a single market maker
or in a limit order book) for an immediate sale (ask) and an immediate purchase (bid). The size of the bid-offer spread in a security is one measure of the liquidity of the market and of the size of the transaction cost
. If the spread is 0 then it is a frictionless asset
.
The trader initiating the transaction is said to demand liquidity, and the other party (counterparty
) to the transaction supplies liquidity. Liquidity demanders place market orders and liquidity suppliers place limit orders. For a round trip (a purchase and sale together) the liquidity demander pays the spread and the liquidity supplier earns the spread. All limit orders outstanding at a given time (i.e., limit orders that have not been executed) are together called the Limit Order Book. In some markets such as NASDAQ
, dealers supply liquidity. However, on most exchanges, such as the Australian Securities Exchange
, there are no designated liquidity suppliers, and liquidity is supplied by other traders. On these exchanges, and even on NASDAQ, institutions and individuals can supply liquidity by placing limit orders.
The bid–ask spread is an accepted measure of liquidity costs in exchange traded securities and commodities. On any standardized exchange two elements comprise almost all of the transaction cost
– brokerage fees and bid-ask spreads. Under competitive conditions the bid-ask spread measures the cost of making transactions without delay. The difference in price paid by an urgent buyer and received by an urgent seller is the liquidity cost. Since brokerage commissions do not vary with the time taken to complete a transaction, differences in bid-ask spread indicate differences in the liquidity cost.
If the USD/JPY currency pair is currently trading at 101.89/101.92, that is another way of saying that the bid for the USD/JPY is 101.89 and the ask is 101.92. This means that currently, holders of USD can sell 1 USD for 101.89 JPY and investors who wish to buy dollars can do so at a cost of 101.92 JPY per 1 USD.
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
(such as stocks, futures contract
Futures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
s, options
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
, or currency pair
Currency pair
A currency pair is the quotation of the relative value of a currency unit against the unit of another currency in the foreign exchange market. The currency that is used as the reference is called the counter currency or quote currency and the currency that is quoted in relation is called the base...
s) is the difference between the prices quoted (either by a single market maker
Market maker
A market maker is a company, or an individual, that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the bid-offer spread, or turn. From a market microstructure theory standpoint, market makers are net sellers of an option to be...
or in a limit order book) for an immediate sale (ask) and an immediate purchase (bid). The size of the bid-offer spread in a security is one measure of the liquidity of the market and of the size of the transaction cost
Transaction cost
In economics and related disciplines, a transaction cost is a cost incurred in making an economic exchange . For example, most people, when buying or selling a stock, must pay a commission to their broker; that commission is a transaction cost of doing the stock deal...
. If the spread is 0 then it is a frictionless asset
Frictionless market
A Frictionless market is a financial market without transaction costs. Friction is a type of market incompleteness. Every complete market is frictionless, but the converse does not hold. In a frictionless market the solvency cone is the halfspace normal to the unique price vector. The...
.
The trader initiating the transaction is said to demand liquidity, and the other party (counterparty
Counterparty
A counterparty is a legal and financial term. It means a party to a contract. A counterparty is usually the entity with whom one negotiates on a given agreement, and the term can refer to either party or both, depending on context....
) to the transaction supplies liquidity. Liquidity demanders place market orders and liquidity suppliers place limit orders. For a round trip (a purchase and sale together) the liquidity demander pays the spread and the liquidity supplier earns the spread. All limit orders outstanding at a given time (i.e., limit orders that have not been executed) are together called the Limit Order Book. In some markets such as NASDAQ
NASDAQ
The NASDAQ Stock Market, also known as the NASDAQ, is an American stock exchange. "NASDAQ" originally stood for "National Association of Securities Dealers Automated Quotations". It is the second-largest stock exchange by market capitalization in the world, after the New York Stock Exchange. As of...
, dealers supply liquidity. However, on most exchanges, such as the Australian Securities Exchange
Australian Securities Exchange
The Australian Securities Exchange was created by the merger of the Australian Stock Exchange and the Sydney Futures Exchange in July 2006. It is the primary stock exchange group in Australia....
, there are no designated liquidity suppliers, and liquidity is supplied by other traders. On these exchanges, and even on NASDAQ, institutions and individuals can supply liquidity by placing limit orders.
The bid–ask spread is an accepted measure of liquidity costs in exchange traded securities and commodities. On any standardized exchange two elements comprise almost all of the transaction cost
Transaction cost
In economics and related disciplines, a transaction cost is a cost incurred in making an economic exchange . For example, most people, when buying or selling a stock, must pay a commission to their broker; that commission is a transaction cost of doing the stock deal...
– brokerage fees and bid-ask spreads. Under competitive conditions the bid-ask spread measures the cost of making transactions without delay. The difference in price paid by an urgent buyer and received by an urgent seller is the liquidity cost. Since brokerage commissions do not vary with the time taken to complete a transaction, differences in bid-ask spread indicate differences in the liquidity cost.
Example: Currency spread
If the current bid price for the EUR/USD currency pair is 1.5760 and the current ask price is 1.5763, this means that currently you can sell the EUR/USD at 1.5760 and buy at 1.5763. The difference between those prices is the spread.If the USD/JPY currency pair is currently trading at 101.89/101.92, that is another way of saying that the bid for the USD/JPY is 101.89 and the ask is 101.92. This means that currently, holders of USD can sell 1 USD for 101.89 JPY and investors who wish to buy dollars can do so at a cost of 101.92 JPY per 1 USD.
See also
- Bid–ask matrix
- High-frequency tradingHigh-frequency tradingHigh-frequency trading is the use of sophisticated technological tools to trade securities like stocks or options, and is typically characterized by several distinguishing features:...
- Market makerMarket makerA market maker is a company, or an individual, that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the bid-offer spread, or turn. From a market microstructure theory standpoint, market makers are net sellers of an option to be...
- Mid priceMid priceIn financial markets, the mid price is the price between the best price of the sellers of the stock or commodity offer price or ask price and the best price of the buyers of the stock or commodity bid price...
- Scalping (trading)Scalping (trading)Scalping, when used in reference to trading in securities, commodities and foreign exchange, may refer to# a fraudulent form of market manipulation# a legitimate method of arbitrage of small price gaps created by the bid-ask spread....
- Spot priceSpot priceThe spot price or spot rate of a commodity, a security or a currency is the price that is quoted for immediate settlement . Spot settlement is normally one or two business days from trade date...