Why bid-ask spread matters

Bavadharini KS | Updated on January 09, 2021

A trade in a stock market, buying or selling of a security, is executed based on the dynamics of demand and supply. The gap or the difference between the highest bid price and lowest ask price defines the spread. It is called as Bid and Ask spread. Bid price is the price at which a buyer is ready to buy and ask price is the price at which a seller is ready to sell. When the two points meet, a trade happens.

When bid and ask prices are close, then the spread is small. For instance, the bid price of L&T’s 1400-strike call option (expiring January 28, 2020) is ₹32.40, while the ask price is ₹32.50. A small spread exists when an index or stock is being actively traded and has a high volume.

On the other hand, when the difference in bid and ask prices are wide, then the spread is said to be large. Consider the case of gold put options contract (expiring January 27, 2020) on MCX (strike price ₹48,000). The bid price is ₹466.5 while the ask price is ₹475. This indicates that this contract is not being actively traded and it has low volume. In other words, the number of contracts being traded is fewer than usual.

While the bid-ask spread have little predictive value in terms of price movement, it still plays an important role and retail investors/traders should care to take note of the same. The spread is an indication of not only liquidity of the security but also the accessibility to buy or sell. So, for a trader or an investor, the smaller the spread of a security, the better it is.

Published on January 09, 2021

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