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Misunderstanding the Bid/Ask Spread in Stock Trading

It’s been my experience that many people don’t really understand how the bid/offer spread plays a part in all markets, including the one for stocks. This post looks to remedy that.

This morning I came across a blog post talking about the bid/ask spread in the stock market. It talks about how the spread is a hidden cost in trading, which it is to be sure. A lot of folks don’t realize that to be the case in stocks since they primarily see just closing value. As with every market, though, there is a bid/ask spread.

The post’s author made some good points in general, but had a few things incorrect. I figure that if he is off in his thinking on the subject, then it’s likely other stock traders and investors are as well. Let me lay it out here.

The first error the post author made was to say that when you trade stocks your broker makes the spread because it is on the other side of the trade. That’s simply not true.

In an exchange driven market like stocks you are rarely trading against your broker – and pretty much never if you’re using a discount broker. Brokers are just pass-through agents. Your order goes into the market and is matched against what’s available there, meaning an opposing order put in by some other trader, probably through some other brokerage (or directly). That other trader could be a market maker, an institution of some sort, or even just some other individual trader like yourself.

The point is, your broker doesn’t keep that money as profit. The people who profit from the spread are the market makers who constantly seek to buy at the bid and sell at the offer. They are essentially being paid for providing liquidity. (Note: Price makers are always better off than price takers).

The author also used the term pay to describe the impact of the spread on your account and that essentially you pay half up front and half when you close out the trade. Again, that’s not quite right.

You never “pay” the spread. Yes, if you go in and buy using a market order your trade value will immediately be lower because you will have bought at the ask(offer) price and would have to sell at the lower bid price. It’s not as though that money actually comes out of your account, though, like a commission. It’s a paper loss.

And you only take the hit to your position value once, when you first put the trade on, not half when you open and half when you close. When you buy you immediately suffer a paper loss equal to the spread value. From that point on, however, your position value is based on the bid price. You don’t take another hit getting out of the trade like you do with your commissions.

Lastly, the blog author said that long-term investing was better than short-term trading because “…it takes less gain to overcome the expenses”. That’s factually incorrect.

If the spread is $0.50 then it takes a $0.50 move in the market in your favor to overcome that cost. Your holding period doesn’t matter. If you’re trading frequently and going after smaller profits, though, the spread does represent a larger portion of your gains, as does the commission. I’m guessing that’s what he really meant.

By John

Author of The Essentials of Trading

10 replies on “Misunderstanding the Bid/Ask Spread in Stock Trading”

John, thank you for your comment and this post. This is why blogging is interesting. I also left this comment on my own blog for you and my readers.

What you said in the first and second paragraphs was the point of the post.

Regarding the inaccuracies:

1. You’re absolutely right. It’s the market maker not the broker that keep the spread.

2. I use the term “pay” very loosely since you only pay money for the trade commission. You “pay” for spread by buying at higher price and get less share; and selling at lower price and get less money.

3. For the last statement, you are more precise, but we are saying the same thing. Short-term implies more trades, which implies more instances of spread loss. These losses are cumulative and become a larger barrier to overcome.

In my blog posts, I tend to generalize certain concepts a bit to get my points across. Thank you for clarifying these points.

Mine is a question: What role does the B/A spread play in analyzing a ticker for entry? What is the significance of a narrow spread vs a wide spread? For example, I am setting up to enter a trade on a stock with a spread of only 0.01. Is that cautionary information to a trader? I recall learning that too wide a spread is a reason to not enter a trade.

William – Generally speaking, a narrow spread indicates a very liquid security, while a wide spread indicates a much less liquid one. That basically means how much you have to give away to enter and exit a trade. For those who trade frequently, wide spreads can seriously impede performance. Those who are long-term players looking to play larger moves in the price don’t have to worry that much – so long as there is sufficient liquidity to get out of one’s position when the time comes.

I can answer that, if the spread is too big of margin related to bid/ask then the stock is not very well liquidated. So if you did buy it, you might have a hard time selling such stock for the price you want even if the market price is going up!! Be careful!!

Dear John, thanks for your comment and i want to ask a question about bid-ask spread use as a proxy of stock market liquidity: can we calculate bid-ask spread in the absence of market maker and specialist like Istanbul Stock Exchange?

Beren – There need not be a market maker or specialist for there to be a spread. The spread reflects the difference between the highest bid order and the lowest offer order in the market at any given time, regardless of the source of those orders. Thus, at any point in time the spread should be readily available from the Exchange real-time pricing stream (though not necessarily from the transaction stream).

Not sure if there will be anyone around to answer this, since it has been a month ago. Any who I was wondering the market maker assuming is an institution they make about 1 cent spread or whatever for every bid/ask (buy/sell). Wouldn’t that make them a guarantee to make money. That is a nice way to do it, how can I get in on the action and become maket maker myself, I mean how much money are we talking about here>….??

Being a market maker does not automatically guarantee easy profits
because they do run the risk of having an unbalanced exposure on the
long or short side which would put them at directional risk.

As for how much they can make, consider the volume of trading done in a single stock and the typical spread and you’ll come up with a starting point. On a million shares a penny spread will make you $10,000.

Do market makers lower the bid in order to ENCOURAGE selling, rather than reflect the actual selling pressure from traders? In other words, who is the chief instigator in the downward price, the seller or market maker?

Market Makers usually spend most of the day inserting their fingers in other market makers rear ends, this is why the spread sometimes is too wide. They measure the spread of the rear end they are inserting their finger in and use the same spread with whatever stock they are focused on. its that simple.

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