The importance of bid-ask spread and how it can affect a trader’s profitability is often overlooked by even the most experienced traders. However, getting a consistent and narrow bid and ask price for your trades can make or break your portfolio, especially for people who trade frequently. Read on as we uncover the secrets to the bid-ask spread.
What Is a Bid-Ask Spread?
A bid-ask spread is the price difference between what a buyer is willing to pay, and what a seller is willing to sell, of an asset. Buying and selling prices are determined by market forces which in turn creates demand and supply of an asset at varying prices. These two preferred prices often do not coincide, and thus, a gap between these two prices results. This gap between the best price a buyer is willing to pay and the best price that a seller is willing to sell, is the bid-ask spread. In the trading world, a bid-ask spread is also called a bid-offer spread.
Since bid and ask prices often do not coincide, trades would often not be possible if they were to be left to natural market forces. Hence, market makers are usually engaged by brokers in the case of stocks, or by exchanges in the case of cryptocurrencies, to close up the bid-ask spread by as much as possible to facilitate trading. Market makers also put up more buying and selling orders in the order book to encourage other traders to put in their own orders. This list of buy and sell orders is commonly referred to as the market depth.
For instance, in the cryptocurrency market, a crypto exchange would typically engage or offer special packages to market makers to put as much bid and ask prices as possible to reduce the bid-ask spread of each listed cryptocurrency. These market makers will then set up different bid-ask spreads for different cryptocurrencies based on their liquidity, historical price volatility, market condition, market risk, and value of the cryptocurrency. A large cap and commonly traded crypto like Bitcoin will typically have a much narrower bid-ask spread than say, a micro-cap altcoin that is not as liquid and is more volatile.
Market makers earn from this bid-ask spread when their buy and sell queues on the order book get filled during their facilitation of actual customer transactions.
How Does the Bid-Ask System Work?
A buyer that wants his buy transaction to be executed instantly should buy at the ask price, while a seller that wants his order to be executed immediately should sell at the bid price.
However, most buyers have their preferred price and will place it on the bid side of the order book, while most sellers have their preferred selling price and will place it on the ask side of the order book. The result is that investors can clearly see the market depth of an asset to gauge its demand and supply.
The job of the market maker is to create a bidding war, which encourages the buyer to raise his bid price increments, and for the seller to start reducing his selling price, until a match occurs at a new compromised price. This price that the buyer and seller agrees to trade at is known as the last price, market price, current price, or even current market price. This price will update with each change in the last transacted price.
A narrow bid-ask spread usually implies an asset with a high demand, while a low demand asset will usually have a wide bid-ask spread. A low demand translates into low liquidity which in turn becomes a self-fulfilling situation as it turns traders away due to the psychological feeling that they will get a larger price discrepancy when they trade the asset.
Bid-Ask Spread Example
Let us give you an example of a bid-ask spread using Bitcoin. In the diagram below, the price quote of Bitcoin you currently see is $19,861.12 on the bid side, and $19,862.05 on the ask side. The bid-ask spread for Bitcoin in this case is thus $0.93 per Bitcoin, while the price in the centre with the larger font, $19,861.97 is the last price.
Image: Bid, Ask and Last Price
The Bid Price
As we have mentioned earlier, the bid price is the highest price buyers in the market are willing to pay for an asset at a particular point in time. When the demand for an asset increases, the bid price will also increase.
Bid Price Example
Using the same Bitcoin example above, a buyer will normally join the current bid by placing a buy order at $19,861.12 to wait for a willing seller to sell Bitcoin to him at $19,861.12. However, if he desires to get his Bitcoin immediately, he can choose to pay $19,862.05 and get his Bitcoin in real-time without having to wait. A less urgent or less bullish buyer may decide to place a limit order at any price below $19,861.12 and wait for sellers to become more desperate and sell down the price and fulfill his buy order at his desired price.
The Ask Price
Exactly opposite to the bid price, the ask price is the lowest price sellers in the market are willing to offer at a particular point in time. When the demand for an asset falls, the ask price will also fall in tandem.
Ask Price Example
Using the same Bitcoin example above, a seller will normally join the current offer by placing a sell order at $19,862.05 to wait for a willing buyer to pay him $19,862.05. However, if he desires to sell his Bitcoin immediately for some reason, he will need to sell it at $19,861.12. On the contrary, a less urgent or less bearish seller may decide to place a limit order at any price higher than $19,862.05 and wait for demand to increase to the point that buyers are willing to pay more and fulfill his desired price.
The Bid-Ask Spread
As we know by now, the difference between the current bid and ask price is called a spread, and that a bid-ask spread can vary between market conditions and cumulative volume of assets.
Wide Bid-Ask Spread
During periods of heightened volatility, or when the liquidity of an asset is low, the bid-ask spread is wide. A less popular asset amongst traders will typically also have a wide bid-ask spread due to less demand.
Narrow Bid-Ask Spread
During times of bull market, when there is more demand for an asset, or when the market risk is low, the bid-ask spread is narrow. A popular asset amongst traders will have a narrow bid-ask spread due to high demand.
Bid-Ask Spread Impact on Cryptocurrency Trading
Bid-ask spread has an especially large impact on cryptocurrency trading due to the inherent volatility of the cryptocurrency market. As we have learnt earlier, volatility of an asset is a determinant for market makers when they decide on the best bid and ask price to put up on the order book.
In addition, as the cryptocurrency market is still nascent and not as mature as the traditional markets, liquidity in many cryptocurrencies is not as good as in other trading markets like the EUR or USD in forex. Pricing information for the market may be harder to get due to lower liquidity in the overall market.
Hence, bid-ask spreads in cryptocurrencies may fluctuate drastically from time to time, which can cause large swings in the profitability of investors who trade frequently. People who engage in day trading should especially make it a habit to monitor changes in bid and ask spreads so as not to get their profits erased by sudden bouts of spread widening.
Conclusion
Understanding the nature of bid-ask spread can help a trader greatly improve his profitability. As a rule of thumb, an ask price is always higher than a bid price and this spread is earned by the exchange or the market maker. During periods of low volume or heightened volatility, a wider bid-ask spread can result, which is the compensation the market maker stipulates in order for him to fill your trade due to a higher risk he is undertaking.
Hence, a trader could decide to not enter a trade when the bid and ask difference is wide and wait for the gap to narrow, or he can choose to place a limit order instead and wait for his desired price to be filled.
Since bid-ask spread is wider for lower volume altcoins compared with large cap coins, a trader may also opt to only trade in large cap and high volume cryptos as opposed to less-known micro-cap altcoins with low trading volume.
Bid and Ask Spread FAQ
Will The Bid-Ask Spread Always Be The Same?
No. The bid and ask spread of an asset will fluctuate with varying conditions like market risk and liquidity factors such as market volume. This is because traders and even market makers, will not want to pay beyond a certain threshold during differing market conditions due to risk management.
What is The Point of a Bid-Ask Spread?
Bid and ask prices can be used to assess the demand and supply of an asset. A trader can also use bid and ask prices to gauge market conditions as a tighter bid-ask spread typically shows that market is functioning well while a wide spread implies that market makers are more wary about market conditions since the bid and ask spread is the compensation charged by market makers to facilitate the filling of our trades. The bid-ask spread further serves as the incentive for the market maker to fulfill your trades.
Should I Buy at The Bid or Ask Price?
If executing your buy trade immediately is your objective, then you should buy at the ask price.
Can Bid-Ask Spread Be Negative?
No. A bid-ask spread cannot be negative because the ask price will always be higher than the bid price. The market makers will ensure this through the effective management of the best bid and ask prices.
