A bid-ask spread is a difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept for an asset. In other words, the Bid-Ask Spread is the price a buyer is willing to pay for something versus the price a seller is willing to get in order to sell it.
What Is Bid-Ask Spread?
In a typical crypto market, the price of an asset is determined by two main players: the buyer and the seller.
The Bid price is the highest price an investor is willing to pay for a security, whereas the Ask price is the lowest price the seller is willing to sell it for. The Bid-Ask spread refers to the difference between the Bid and Ask prices.
Essentially, the bid-ask spread can be formed in two ways. First, it can be created as a way for a broker (or trading intermediary) to monetize their service. Second, it can be generated solely by differences in limit orders placed by traders on an open market.
How Does Bid-Ask Spread Work?
A bid-ask spread not only helps determine the current price of an asset but also allows market makers to profit from the spread. Market makers in a traditional market are typically the broker and the trading platform.
Market makers control the bid-ask spread because they provide liquidity to the market. The spread enables them to profit from their trading activities.
The market-maker model is not used by everyone. Crypto exchanges do not rely on DeFi because of its decentralized nature. Because market participants place orders directly into a crypto platform’s order book, the market price is determined by supply and demand. In this case, the crypto exchange charges a trading fee for each transaction so it can earn revenue.
The bid-ask spread can be thought of as a measure of supply and demand for a specific asset. Because the bid represents supply and the ask represents demand for an asset, when these two prices diverge, the price action reflects a change in supply and demand.
The depth of the “bids” and “asks” can significantly affect the bid-ask spread. If fewer participants place limit orders to buy a security (resulting in lower bid prices) or fewer sellers place limit orders to sell, the spread may widen significantly. As a result, when placing a buy limit order, keep the bid-ask spread in mind to ensure it executes successfully.
Market makers and professional traders who recognize imminent risk in the markets may also increase the spread between the best bid and best ask they are willing to offer at any given time. If all market makers do this on a given security, the quoted bid-ask spread will be larger than usual. Some high-frequency traders and market makers attempt to profit from changes in the bid-ask spread.
Bid-Ask Spread and Liquidity
The size of the bid-ask spread differs from one asset to the next due to the liquidity of each asset. The bid-ask spread is widely used as a proxy for market liquidity. Certain markets are more liquid than others, and their lower spreads should reflect this. Transaction initiators (price takers) require liquidity, while counterparties (market makers) supply liquidity.
The currency, for example, is considered the most liquid asset in the world, and the bid-ask spread in the currency market is one of the smallest (one-hundredth of a percent); in other words, the spread can be measured in fractions of pennies. On the other hand, less liquid assets, such as small-cap stocks, may have spreads that are equivalent to 1% to 2% of the asset’s lowest ask price.
Bid-ask spreads can also reflect the market maker’s perceived risk in making an offer. Options or futures contracts, for example, may have bid-ask spreads that are a much larger percentage of their price than a forex or equities trade. The spread’s width may be determined not only by liquidity but also by how quickly prices can change.
Importance of Bid-Ask Spread
Keep an eye on the bid-ask spread if you’re new to trading financial instruments. Because there are many buyers and sellers in the market, a tight bid-ask spread usually indicates a liquid cryptocurrency. Most well-known crypto pairs typically have tight spreads, in which case the bid-ask spread is irrelevant.
Lesser-known and newer cryptocurrencies, on the other hand, may have wide bid-ask spreads, which means you may not get the price you want. For example, if a cryptocurrency’s Ask price is $1.60 and the bid price is $1.40, the bid-ask spread is $0.20 — or 12.5% of the Ask price. In this case, only purchase the cryptocurrency if you intend to keep it for the long term.
If the bid-ask spread is greater than 1%, use a limit order to get your desired price without incurring a significant loss. Another option is to look for a different trading exchange that may have a better spread on the specific crypto pair.
Bid-Ask Spread Example
If the bid price for a stock is $19 and the Ask price is $20, the bid-ask spread for the stock in question is $1. The Aid-Ask spread can also be expressed as a percentage; it is typically calculated as a percentage of the lowest sell or ask price.
The bid-ask spread in percentage terms for the stock in the preceding example would be calculated as $1 divided by $20 (the bid-ask spread divided by the lowest ask price), yielding a bid-ask spread of 5% ($1 / $20 x 100). If a potential buyer offered to buy the stock at a higher price or a potential seller offered to sell the stock at a lower price, this spread would close.
A bid-ask spread is the difference between the asking and offering prices of a security or other asset in financial markets. The bid-ask spread is the difference between the highest price a buyer is willing to offer (the bid price) and the lowest price a seller is willing to accept (the Ask price).
An asset with a narrow bid-ask spread is usually in high demand. Assets with a wide bid-ask spread, on the other hand, may have a low volume of demand, influencing larger price discrepancies.