The bid-offer spread, sometimes called the bid-ask spread, is simply the difference between the price at which you can buy a share and the price at which you can sell it.
For example, let’s say that a stock is priced at $50 in the market. Its “bid” price is $49.90 and “offer” or “ask” price is $50.10. This means that $50.10 would be the highest price that the buyer is willing to pay for the stock and the lowest price that the seller is willing to accept in order to sell it. It can also be expressed as a percentage – in this case 0.2% [($50.10 – $50.00) / ($50.00)].
The spread would close if a prospective buyer agreed to buy the stock at a higher price or a prospective seller agreed to sell the stock at a lower price. Wide bid-offer spreads are typical for illiquid securities. Market makers are security dealers who undertake the business of agreeing to buy and sell certain securities at specific prices to aid in the liquidity of a market.
Highly liquid stocks, such as Google (GOOG), will generally have a bid-offer spread of less than one cent or under 10 basis points (<0.10%). Spreads are also tighter for more liquid currency pairs and typically less than 2 basis points (<0.02%).
On the other hand, illiquid markets, such as those for thinly traded fixed income securities and small cap stocks, can see bid-offers spreads of over 1% of the asset’s price.
A bid-offer spread is fundamentally a function of supply and demand in the market for a particular security. The bid represents demand while the ask or offer represents the supply. Differences in bid-offer spreads between different exchanges are subject to arbitrage to opportunities.
The Bid-Offer Spread and Its Importance to Day Traders
Trading illiquid securities can make sense in certain scenarios to obtain a specific type of exposure. Moreover, investors expect to be compensated extra for holding illiquid securities in what is called an “illiquidity premium”.
But the drawbacks include the need to pay an above-market price to buy a security, the potential inability to sell a security when desired, and the need to sell at some type of discount to get out of a position. This is why many traders always prefer to stay liquid, knowing they can effectively get in and out at any price.