Bid-offer spread
The bid/offer spread (also known as bid/ask orbuy/sell spread) forsecurities (such asstocks, futures contracts,options, orcurrency pairs) is the difference between the prices quoted (either by a singlemarket maker or in a limit order book) for an immediate sale (ask) and an immediate purchase (bid).The size of the bid-offer spread in a security is one measure of the liquidity of the market and of the size of thetransaction cost.[1]
The trader initiating the transaction is said to demand liquidity, and the other party (counterparty) to the transaction supplies liquidity. Liquidity demanders placemarket orders and liquidity suppliers placelimit orders. For a round trip (a purchase and sale together) the liquidity demander pays the spread and the liquidity supplier earns the spread. All limit orders outstanding at a given time (i.e., limit orders that have not been executed) are together called theLimit Order Book. In some markets such asNASDAQ, dealers supply liquidity. However, on most exchanges, such as theAustralian Securities Exchange, there are no designated liquidity suppliers, and liquidity is supplied by other traders. On these exchanges, and even on NASDAQ, institutions and individuals can supply liquidity by placing limit orders.
The bid-ask spread is an accepted measure of liquidity costs in exchange traded securities and commodities. On any standardized exchange two elements comprise almost all of thetransaction cost – brokerage fees and bid-ask spreads. Under competitive conditions the bid-ask spread measures the cost of making transactions without delay. The difference in price paid by an urgent buyer and received by an urgent seller is the liquidity cost. Since brokerage commissions do not vary with the time taken to complete a transaction, differences in bid-ask spread indicate differences in the liquidity cost.[2]
Example: Currency spread
If the current bid price for the EUR/USD currency pair is 1.5760 and the current ask price is 1.5763, this means that currently you can sell the EUR/USD at 1.5760 and buy at 1.5763. The difference between those prices is the spread.
If the USD/JPY currency pair is currently trading at 101.89/101.92, that is another way of saying that the bid for the USD/JPY is 101.89 and the ask is 101.92. This means that currently, holders of USD can sell 1 USD for 101.89 JPY and investors who wish to buy dollars can do so at a cost of 101.92 JPY per 1 USD.
References
- ^ Spreads - definition
- ^ Demsetz, H. 1968. "The Cost of Transacting." Quarterly Journal of Economics 82: 33-53http://web.cenet.org.cn/upfile/100078.pdfdoi:10.2307/1882244JSTOR1882244