Bid Ask Spread
Bid-ask spread (also called bid-offer spread) is the excess of the price at which a financial market participant is willing to sell a financial instrument (the ask or the offer) over the price at which he is willing to buy it (the bid).
Bid-ask spread is the mechanism by which dealers in the quote driven markets are compensated.
Market bid-ask spread equals the excess of the best ask (the lowest ask) over the best bid (the highest bid. Though every participant in a quote-driven market has his own bid and ask prices, the market bid-ask spread is different from individual bid-ask spreads.
Bid-ask spread depends on market liquidity and volatility of the relevant financial instrument (i.e. stock, currency, bonds, etc.)
Bid-Ask Spread = Ask Price − Bid Price
Market Bid-Ask Spread = Best Ask Price − Best Bid Price
Ask/offer price (or ask) is the price at which the dealer sells and bid price (or bid) is the price at which he purchases it.
Example 1: Stock Bid-Ask Spread
Low-cap stocks are normally traded on quote-driven markets. Best bid/best ask (market bid ask) for Tesla Motors, Inc. (TSLA) on NASDAQ as on 18 July 2012 is $118.28/$118.49. This gives us a bid ask spread of $0.28 [= $118.49 − $118.28].
This means if you have 100 shares of Tesla, you can sell them for $11,828 [= $118.28 × 100], however, if you want to purchase 100 more shares of Tesla, you will have to pay $11,849 [= $118.49 × 100].
Example 2: Currency Bid-Ask Spread
Forexica sells Euro at 1.3093€/$ and purchases it at 1.3089€/$. Find the bid-ask spread.
1.3093 is the sale price, so it is the ask. 1.3089 is the purchase price, and hence the bid. This gives us a bid-ask spread of 0.0004 [= 1.3093 − 1.3089] or 4 pips. In foreign currency markets this 4th decimal is called one pip.
Example 3: US Treasuries Bid-Ask Spread
US treasuries bid-ask quotes are expressed in terms of multiples of 1/32s.
Bid-ask quote for a $1,000 US bond that carries 6% coupon rate and matures in 15 years is 103.16 − 28. It means the dealer is willing to buy the bond for $1035 [= (103 + 16/32)/100 × $1,000]. He is willing to sell the same bond for $1,037.5 [= (103 + 24/32)/100 × $1,000].
Written by Obaidullah Jan