Every share has two prices at any moment. The bid is the highest price a buyer is currently willing to pay. The ask, also called the offer, is the lowest price a seller is currently willing to accept. The gap between them is the bid-ask spread. It is one of the least visible costs in trading, and one of the most important, because you pay it on every round trip.
This guide explains how the spread arises, how to measure it, what drives it up or down, and how to account for it when you plan a trade.
How the spread arises
Buyers and sellers do not always agree on a price. Buyers want to pay as little as possible, and sellers want to receive as much. The bid and the ask show where each side currently stands. When the best bid and best ask match, a trade happens. Until then, the two prices sit apart.
The market maker or the market's order book provides the liquidity that makes trades possible. Market makers quote both a bid and an ask, and they earn the spread for providing that service. The spread compensates them for the risk that the price moves against them while they hold the shares.
A worked example
Suppose a share has a bid of 99.80 and an ask of 100.20.
- The spread is 100.20 minus 99.80, which is 0.40.
- The midpoint is the average of the two, which is 100.00.
- The spread as a percentage of the midpoint is 0.40 divided by 100.00, which is 0.4 percent.
If you buy 100 shares at the ask of 100.20, you pay 10,020. If you sell them straight away at the bid of 99.80, you receive 9,980. The round trip costs you 40, before commissions and taxes. The price did not move, but you lost 0.4 percent.
This is the key lesson. On a share with a wide spread, the price must move at least the spread in your favour before you break even, even if you do nothing else. The spread is a hurdle every trade has to clear.
What drives the spread
The spread depends mainly on liquidity. Liquidity is the ease of buying and selling without moving the price. Several things tend to make a spread wider.
Low trading volume. Fewer buyers and sellers means fewer orders waiting at each price, so the gap between them widens.
Small company size. Smaller companies are usually traded less, and they often have fewer market makers.
High volatility. When prices move quickly, market makers face more risk, so they widen the spread to protect themselves.
Market conditions. Spreads tend to widen around the open and close of the session, around news, and during periods of stress.
Less competition. A share with few market makers can have a wider spread than a similar share with many.
Spreads narrow for the opposite reasons. Large, heavily traded shares usually have tight spreads, sometimes a single tick wide.
Spread and the tick size
The smallest price step a share can move is called the tick size. A spread can only be as narrow as one tick. In a cheap share with a small tick, the spread can be a tiny percentage. In an expensive share with a large tick, even one tick can be a noticeable percentage. Compare the spread as a percentage of the price, not as a number of rupees or dollars.
Why the spread matters more for frequent trading
If you trade once a year, the spread is a small part of your return. If you trade often, the spread adds up. A strategy that makes a small expected gain per trade can be wiped out by the spread on each trade. A trader who makes many short trades in a wide-spread share can lose money even when the average trade looks good before costs.
This is why short-term trading in illiquid shares is hard. The spread is a cost you pay every time, and it is much easier to beat when you trade less often and in shares that are easy to buy and sell.
Trading into the spread
When you place a market order to buy, you pay the ask. When you place a market order to sell, you receive the bid. This is trading into the spread. Using a limit order can sometimes help you trade inside the spread, by offering a price between the bid and the ask. The trade fills only if a counterparty agrees to that price, so it may not fill.
Think of it this way: a limit order is a request to trade at a price you choose. A market order accepts the price the other side is offering now. The spread is the difference between those two prices.
How to check the spread before you trade
- Look at the current bid and ask on your platform, not just the last traded price. The last price can be from a trade that has already passed.
- Work out the spread as a percentage of the midpoint.
- Compare the spread with the move you expect. If the expected gain is smaller than the spread, the trade needs a larger move to pay off.
- Check the volume. A share with little volume is likely to have a wide spread.
- Avoid trading in the first and last few minutes of the session, when spreads are often wider.
The spread and costs
The spread is not the only cost. Commissions, taxes and fees also apply. Add all of them together to find the true cost of a round trip. A commission of 0.1 percent on each side, plus a spread of 0.4 percent, is a total cost of about 0.6 percent before any tax. For a short-term trade, that is the hurdle the price has to clear before you make money.
A spread that looks small in a price quote can be large against a share's typical daily move. Before you decide a trade is worth taking, compare the round-trip cost with the move you expect, and with how far the share usually travels in a day.
Common mistakes
Ignoring the spread because the commission is low. The commission may be small, while the spread is the larger cost.
Using the last traded price to calculate a gain. The price you can actually sell at is the bid, and the price you buy at is the ask.
Trading in a thin share with a market order. You pay the spread, and possibly more, because a market order can move through the book.
Assuming the spread is fixed. It changes through the day and with the news, so check it each time.
Key takeaways
The bid-ask spread is the gap between the best buy price and the best sell price. It is the cost of trading immediately, and you pay it on every round trip. It is wider in illiquid, volatile or thin shares, and tighter in large, heavily traded ones. Measure it as a percentage of the price, count it in your expected return, and use limit orders with care. For frequent traders the spread is a major cost, and it can decide whether a strategy makes or loses money.
This guide is for general information, not financial advice. See the disclaimer.