by The term bid and ask (also known as bid and offer) refers to a two-way price quotation that indicates the best potential price at which a security can be sold and bought at a given point in time. The bid price represents the maximum price that a buyer is willing to pay for a share of stock or other security. The ask price represents the minimum price that a seller is willing to take for that same security. A trade or transaction occurs after the buyer and seller agree on a price for the security which is no higher than the bid and no lower than the ask.
The difference between bid and ask prices, or the spread, is a key indicator of the liquidity of the asset. In general, the smaller the spread, the better the liquidity.
The Role of Bid Price and Ask Price in Liquidity
Typically, when there is a big difference between the bid price and the ask price of a security, it means there is not much trading going on. This is not a good thing when you are a seller, because it can leave you stuck with a stock you don’t want to own.
In contrast, the narrower the spread between the bid price and the ask price of a security, the easier it is to sell. This is a very good thing as a seller, because it means there is plenty of trade volume around the ask price. This, in turn, means less risk as an investor.
Think of it like this, as a kid, if you decided to open a lemonade stand in the middle of winter when the demand for lemonade is low and sell each cup for $5, if customers were only willing to pay $1, you would be experiencing a bid-ask spread of $4. Now, you could choose to sell your lemonade for a significantly lower price, and cut your losses. Or, you could choose to hold at your price, but you might end up waiting until July before somebody was willing to buy a cup at your ask price. This is an example of low liquidity.
Meanwhile, if you lowered your price to $1.01, because the difference between your ask price and the bid price of your customers was much smaller, you would have a much easier time selling your lemonade. In other words, you would be much more liquid.
The same applies to buying and selling securities. The closer the bid price and the ask price are to one another, the more liquid the security is.
3 Factors That Affect Bid Price And Ask Price
When it comes to the bid-ask spread, there are a number of factors that can affect how wide or narrow it is. In this next section, we will cover three of them.
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Market Size
The larger the market size and trading volume that happens on a daily basis for a particular security, the narrower the bid-ask spread is likely to be. Which makes total sense if you think about it. I mean, if there are 1 million people wanting to buy a particular stock, it is much more likely that you will be able to sell it if you need to liquidate your shares.
On the other hand, if you are trying to sell a particular security, but there are only 100 people interested in buying it, you are much less likely to sell for a high price.
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Volatility
In short, volatility widens the bid-ask spread. Why? Because if the price of a security jumps and falls wildy, or without any predictability, market-makers have a much harder time setting the ask price or the bid price. Remember, unpredictability is the opposite of liquidity. This lack of liquidity is reflected in the bid-ask spread.
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Political/Economic Uncertainty
When people are uncertain about the political or economic climate, people tend to play it safe with their investments. In other words, sellers stop selling, and buyers stop buying. Or at least, sellers stop dropping their ask price, and buyers stop increasing their bid price.
Benefits of Bid-Ask Spread
The bid-ask spread works to the advantage of the market maker. Continuing with the above example, a market maker who is quoting a price of $10.50 / $10.55 for security A is indicating a willingness to buy A at $10.50 (the bid price) and sell it at $10.55 (the asked price). The spread represents the market maker’s profit.
Bid-ask spreads can vary widely, depending on the security and the market. Blue-chip companies that constitute the Dow Jones Industrial Average may have a bid-ask spread of only a few cents, while a small-cap stock that trades less than 10,000 shares a day may have a bid-ask spread of 50 cents or more.
The bid-ask spread can widen dramatically during periods of illiquidity or market turmoil, since traders will not be willing to pay a price beyond a certain threshold, and sellers may not be willing to accept prices below a certain level.
