What is a bid-ask spread?

When you think about trading a stock, you likely think about how that stock may appreciate in value over time. However, you should also pay attention to the price you get for the transaction. The difference between your offer and the final sale price can add up if you trade often, and it can also tell you a lot about the health of your asset. This difference is known as the bid-ask spread.    

Why should the bid-ask spread matter to you?

The bid-ask spread provides a credible snapshot of the current supply-demand relationship for a particular asset. For example, asset classes like real estate may have a very wide bid-ask spread – anyone who’s looked at a house listing that’s been on the market for months has witnessed this. If the ask price is above what anyone is willing to bid for it, it means the demand for that asset at that specific price is very low.

Liquidity is another way to think about the market for these kinds of assets. A tight bid-ask spread indicates that the asset is very liquid, meaning you can sell it or buy it easily. Stocks or exchange-traded funds (ETFs) that have a wide bid-ask spread may be difficult to buy or sell at the price you want – much like a house that’s been sitting on the market for months, it isn’t a very liquid asset.

On the other hand, if there are more buyers than sellers of a stock (e.g., the supply is unable to meet demand), then the bid-ask spread could widen and the price of the asset may go higher. This is good for owners who want to sell at a higher price.

Who determines the bid-ask spread?

Ultimately, bid-ask spreads are determined by prevailing market conditions. However, the people who analyze and set the bid-ask spreads are known as market makers. As is implied by the name, these makers “make a market” in the assets so that investors can engage in transactions. But what does it mean to make a market, exactly?

Market makers help keep stock markets liquid, or so that it’s relatively easy and inexpensive to enter and exit the market and to ensure that there are plenty of offers available. Typically, market makers are central banks and/or other financial institutions, even though some individuals may be market makers in certain cases. Another way of thinking of liquid markets is that you can sell an asset within them without significantly affecting its price. In a word, market makers help keep markets and asset prices relatively stable so that they accurately reflect the current market supply and demand.

In stock markets, market makers are seen as “wholesalers,” mainly because they typically will put in a bid to buy an asset “in bulk” from an investor. These bids signal to investors that this is the maximum price market makers are willing to pay to buy the asset in the current market environment.

Similarly, the market maker offers to sell the asset to a different investor at the ask price. This is why the ask price is sometimes referred to as the offer price. This means that this is the minimum price they’re willing to sell the asset at in the current market environment.

The market maker has access to a large pool of stocks to facilitate buying and selling between investors.

Stock exchanges, like the New York Stock Exchange (NYSE), rely on Designated Market Makers (DMMs) and floor brokers to set these spreads so that they best reflect current market conditions for these financial instruments. This, in turn, ensures that investors have access to “fair and orderly markets.”

What’s in it for the market maker?

Aside from cultivating these fair and orderly markets, the market maker generates revenue from the bid-ask spread. This is one of the key ways market makers make money. To understand this better, you must examine the bid-ask spread from the market maker’s perspective.

The key point is that the ask price must be higher than the bid price for them to make money. This is in line with the “buy low, sell high” mantra that is required for profitability.

Take note that this appears opposite to the way investors and traders view the bid-ask spread. This is because investors and traders are “price takers,” meaning they have to take the price given if they want to buy or sell. The bid-ask spread is the transaction cost that the investor pays to transact the asset.

Bid-ask spread example

Let’s say that ABC Ltd. is a mega-cap stock that is in demand with investors – this means that it will be highly liquid. Currently, its stock is trading at $50.10 (bid) – $50.15 (ask). The bid-ask spread is $0.05.

If you want to buy this stock, you can purchase it for $50.15. The market maker who sold you the stock at this price can go and buy ABC at $50.10 from an investor seeking to sell, or from another market maker. They will have made the bid-ask spread of $0.05 as profit.

The bottom line

When it comes to determining a particular asset’s liquidity, the bid-ask spread can be a useful tool. Understanding the supply-demand relationship of an asset can help you determine whether you want to incorporate that asset into your financial strategy. For more information on how to use the bid-ask spread to your advantage, connect with a J.P. Morgan advisor today.

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