Bid Ask Spread: How It Works and Why It Matters
When you look at a stock quote, you never see just one price. You see two.
One is what buyers are willing to pay. The other is what sellers are asking. The difference between those numbers is the bid ask spread, and it is a real cost every trader should understand.
What Is the Bid Ask Spread?
The bid ask spread is the gap between the highest price a buyer is willing to pay for an asset and the lowest price a seller is willing to accept.
It exists on every tradable asset, like stocks, ETFs, and options. The spread is usually small on popular, heavily traded names and larger on thinly traded or more risky assets.
Bid, Ask, and Spread Explained
You can think of a quote as three basic parts:
What is Bid?
The highest price buyers are currently offering to pay. If you sell at market, you sell to the bid.
What is Ask (or offer)?
The lowest price sellers are currently willing to accept. If you buy at market, you buy at the ask.
Understanding Spread
Spread is the difference between the ask and the bid.
Spread = Ask price minus Bid price.
Market makers and liquidity providers sit between buyers and sellers and often earn the spread as compensation for taking on risk.
Example
Imagine a stock with this quote:
- Bid: 10.00 dollars
- Ask: 10.05 dollars
The bid ask spread is 0.05 dollars.
If you:
- Buy at market, you pay 10.05 dollars.
- Immediately sell at market, you receive 10.00 dollars.
You would lose 0.05 dollars per share instantly, even though the price did not move. That 0.05 dollars is the cost you paid through the spread.
Why Does the Spread Exist?
The spread is not a bug. It is how the market pays people who provide liquidity and take risk.
Market makers quote both buy and sell prices all day. They stand ready to trade with you when you want to buy or sell.
In return, they:
- Earn the spread part of the time.
- Take risk that prices can move against them.
In more liquid markets, competition between market makers pushes spreads very tight.
In less liquid or more volatile markets, spreads widen to reflect higher risk.
Why the Spread Matters For You?
The bid ask spread is one of the most important hidden costs of trading.
It can affect you in several ways:
- It reduces your effective return when you enter and exit a position.
- It matters more for short term traders who trade frequently.
- It matters less for long term investors who hold for years.
If you regularly buy and sell assets with wide spreads, your costs can quietly add up even if your broker advertises zero commissions.
What Affects the Size of the Spread?
Several factors influence how tight or wide a spread is:
Liquidity and volume
Popular stocks like Apple or Microsoft trade millions of shares daily and tend to have very tight spreads.
Thinly traded small caps often have wider spreads.
Volatility
When prices move fast, market makers take more risk, so spreads usually widen.
Time of day
Spreads tend to be tighter during the most active trading hours and wider near the open, the close or in after hours trading.
Price level
Lower priced stocks can show larger spreads in cents, and very cheap stocks can feel jumpy even on small moves.
Watching the spread for a few seconds before you place an order will quickly show you how “expensive” a stock is to trade.
How Order Types Interact With the Spread
The type of order you use affects how you pay or manage the spread.
Market orders
You ask to trade immediately at the best available price.
If you buy with a market order, you almost always pay the ask and cross the full spread.
If you sell with a market order, you almost always hit the bid.
Limit orders
You set a maximum price you will pay to buy or a minimum price you will accept to sell.
You can place your buy limit between the bid and ask and sometimes “improve” the spread if the market trades with you.
For beginners, a simple rule is: use market orders only when the spread looks tight and the stock is very liquid.
Otherwise, consider limit orders so you stay in control of the price you pay or receive.
Practical Tips For Beginners
Referring to Investopedia, here are some simple habits that can help you manage bid ask spreads:
Check the spread before every trade
- A 0.01 dollar spread on a large cap stock is usually fine.
- A 0.50 dollar spread on a 5 dollar stock is a warning sign.
Trade during normal market hours
Spreads are often widest near the open, near the close and in extended hours. Mid session trading can be cheaper in spread terms.
Do not overtrade
Every trade crosses a spread or sits in the order book. Fewer, higher quality trades often beat many low conviction trades.
Conclusion
The bid ask spread is the small but important gap between what buyers bid and what sellers ask in the market.
It is a real part of your trading cost, especially if you trade frequently or in less liquid names.
By paying attention to spreads, using limit orders wisely and focusing on liquid assets, you keep more of your returns over time.
When you invest through an app like Gotrade, you still see the same fundamental mechanics of the market.
Understanding bid ask spreads helps you become a more informed investor as you explore US stocks and ETFs, even if you are starting with small amounts.
FAQ
- What is the bid ask spread in simple terms?
It is the difference between the highest price buyers will pay and the lowest price sellers will accept for a stock. - Is a smaller spread always better?
Generally yes. A tighter spread usually means better liquidity and lower trading costs, which is helpful for most investors. - How can I reduce the cost of spreads?
Trade liquid stocks and ETFs, avoid very wide spreads, prefer normal market hours and use limit orders so you control your entry and exit prices.
Disclaimer:
Gotrade is the trading name of Gotrade Securities Inc., which is registered with and supervised by the Labuan Financial Services Authority (LFSA). This content is for educational purposes only and does not constitute financial advice. Always do your own research (DYOR) before investing.
