How to Determine the Bid-Ask Spread

How to Determine the Bid-Ask Spread

Submitted by adil on Thu, 05/15/2014 - 19:33

The price set by the seller for a security is called the ask price, while the price, a buyer is offering to buy it, is called the bid price. The difference between these two prices is known as the bid-ask spread. This spread is directly proportional to the supply and demand of the security. More sellers than buyers mean the bid price will get lower due to high supply, and if there are more buyers than sellers, the bid price will become higher because of soaring demand. The bid-ask price also depends upon the liquidity of the security. Let us see some examples which will help you calculate bid-ask difference is various cases:

Example 1: Consider a stock with a bid price of $9.95 and an offer price of $10.00. These prices are usually written as a fraction $9.95/$10.00. The bid-ask spread in the current scenario is $10.00 - $9.95 = 5 cents ($0.05), as a percentage which is $0.05/$10.00 = 0.50%.

If the buyer buys a single share and immediately sells at the same rates, he will incur a loss of $0.05. If he does this with 100 shares (total bid price of $1,000) the loss will be $5, with 10,000 shares (total bid price of $100,000), the loss will increase to $500. You can see that the spread percentage remains 0.50% with all the trades.

Example 2: Now take the example of a Forex trader who buys EUR 100,000 with a leverage ratio of 50:1, with current market rate as EUR 1 = USD 1.3300/1.3302. The bid-ask spread in the current scenario is $0.0002, as a percentage which is $0.0002/$1.3302 = 0.015% of the price for EUR 100,000.

Quick note: Forex trading is usually done with high leverage ratios. If you want to calculate what the bid-ask spread cost is as a percentage in terms of leverage; just multiply spread percentage with the amount of leverage. So, for above example, it will be 0.015% x 50 = 0.75%.

Example 3: Let us take the example of an option trade with a particular asset. A trader bought a short-term call option on XYZ stock with prices of $0.72/$0.73. The bid-ask spread is $0.01, which is insignificant, but the spread percentage is quite high at 1.37%.

The underlying stock is being traded at $31.39/$31.40, with the same spread of a penny, but with a much lesser 0.032% spread percentage.

Quick note: A professional option trader will not consider the high spread percentage for option trading in current scenario, because the call option will definitely mean profits because of the higher bid price. And this action is also encouraged by the fact that very less investment capital is required to trade on options as compared to the original underlying asset.

If you are doing trades regularly, you must put attention to the bid-ask spread costs. This is a hidden expense that can prove to be detrimental for a novice trader if totally ignored, because this spread changes profits into losses. The effects of this spread can be avoided by trading securities with narrow spreads and using limit orders. Whatever method you choose, it is necessary that you calculate the spread costs correctly before implementing the right strategy.