A bid-ask spread is defined as the difference between the asking price, and the bidding price of a security. This article explains about this spread in detail, along with factors you can execute to benefit from it.
Stock market investments have proven to be an effective medium of wealth creation. The returns earned on market investments can help you fulfil several short and long-term financial goals. However, it takes immense effort to understand and then master the investment market. You have to familiarise yourself with various jargon and terminologies. One term that investors and traders commonly use is the bid-ask spread.
What is bid-ask spread?
In the investment market, a bid-ask spread is defined as the difference between a stock’s asking (or offer) price, and the bidding (or buying) price. The asking price is essentially the value point at which sellers are ready to sell their securities, whereas the bid price is regarded as the point at which buyers are prepared to make the purchase. The point where the two-value points meet in the marketplace, i.e. when buyers and sellers agree to the asking and bidding prices offered by one another, a trade takes place.
A bid-ask spread is typically expressed in both absolutes, as well as in terms of percentage. In a highly liquid market, spread values tend to be very small, however in a less liquid market; the spread value can be rather significant.
How is the bid-ask price determined?
The bid-ask price is typically determined by the two most common market forces – demand and supply. Supply is defined as the abundance or volume of a particular security in the marketplace; for instance, the supply of stocks available for sale. Demand, on the other hand, refers to an investor’s willingness or inclination to pay a specific price for the underlying security.
The bid-ask spread signifies the levels where buyers will buy the securities, and sellers will sell them. A constricted or tight bid-ask spread may even serve as an indication for an actively traded stock with good liquidity. Conversely, a wide bid-ask spread could indicate the exact opposite. As such, the gap between the demand and supply defines the spread between the buying and selling prices. The more significant the gap, the bigger the spread.
How to benefit from the bid-ask spread
If you wish to benefit from bid-ask spread, you can do so by following various types of orders. They are as under:
1. The market order
A market order is defined as a trade order to sell or buy securities immediately. While specialists can guarantee the execution of the order, they cannot guarantee the price at which the trade is executed. As per bid-ask spread, a market order is executed at (or close to) standing bid-ask level.
2. The limit order
The limit order enables the buying and selling of securities at a particular price or higher. As an investor, you should know the variants associated with limit orders. For instance, buy limit orders are mainly executed at or lower than the security’s limit price. So, if you place an order to purchase securities of ABC Corp, at a rate higher than say Rs. 200 per share, then your order will only be executed if the price of the stock is lower than Rs. 200.
3. The stop order
Also known as “stop-loss”, a stop order is defined as the order or instruction to purchase or sell a stock, once it reaches a specific price level. This level is also called a stop-price; a trade can be executed, as soon as the stop-order reaches it. The stop order is typically executed as a limit order. It is further categorised as a buy stop order and a sell stop-order.
The bid-ask spread is one of the most crucial components in the process of executing trades. Understanding bid-ask spread trading strategies can make you a knowledgeable, better trader. If you wish to learn how to apply the bid-ask spread and learn trading strategies, you can consult our team of financial advisors at Angel One.