Definition: Bid-Ask Spread is typically the difference between ask (offer/sell) price and bid (purchase/buy) price of a security. Ask price is the value point at which the seller is ready to sell and bid price is the point at which a buyer is ready to buy. When the two value points match in a marketplace, i.e. when a buyer and a seller agree to the prices being offered by each other, a trade takes place. These prices are determined by two market forces -- demand and supply, and the gap between these two forces defines the spread between buy-sell prices. The larger the gap, the greater the spread! Bid-Ask Spread can be expressed in absolute as well as percentage terms. When the market is highly liquid, spread values can be very small, but when the market is illiquid or less liquid, they can be large.
Description: Calculation of Bid-Ask Spread:
Bid-Ask Spread (absolute) = Ask/Offer Price – Bid/Buy Price Bid-Ask Spread (%) = ((Ask/Offer Price- Bid/Buy Price) – Ask/Offer Price)*100
Example: Gold (December) futures contract on MCX has best buy price at Rs 26,473 and best sell price at Rs 26,478. So the Bid-Ask Spread is equal to (Rs 26,478-Rs 26,473) = Rs 5 and the percentage spread will be equal to ((5/26,478)*100) = 0.019% There can be various buyers and sellers in the market and they may be willing to buy/sell any security at different price points. So, all price points cannot be used to calculate Bid-Ask Spread. This can be calculated by using the lowest Ask Price (best sell price) and highest Bid Price (best buy price). The Bid-Ask Spread is one of the important trading points in the derivatives market and traders use it as an arbitrage tool to make little money by keeping a check on the ins and outs of Bid-Ask Spread.
Bid-Ask spread is used in following arbitrage trades:
1) Inter-market spread : When a trader buys the futures of a security having a particular expiry on one exchange and sells the same security contract with a near-expiry on another exchange,
2) Intra-market spread : When the contract of one security is bought and that of another security is sold on the same exchange e.g. gold and silver spread trade,
3) Calendar spread : When a security contract of one expiry date is bought and another contract of the same security with a different expiry date is sold on the same exchange.
Some of the important elements to Bid-Ask Spread: 1) The market for any security should be highly liquid, otherwise there may be no ideal exit point to book profit in a spread trade.
2) There should be some friction in demand-supply of that security, because that creates chances for a wider spread.
3) A trader should not use ‘market order’ for spread trade, otherwise the spread opportunity can be missed. It’s wise to use ‘limit order’ where the trader decides the entry point.
4) The range of a spread trade is relative to that particular security market, it’s not same for all.
5) Always check Bid-Ask Spread ins and outs, and look for spreads either in absolute or percentage terms for individual security. If it’s a margin trade, then use spread percentage.
6) Bid-Ask Spread trade involves a cost, as you are doing two trades simultaneously.
7) Bid-Ask Spread trades can be done in almost all kinds of securities, but they are quite popular in forex, interest rate yields and commodities.
Souce : Sasha Evdakov
As a seasoned financial expert with extensive experience in trading and market dynamics, I have a deep understanding of the Bid-Ask Spread and its significance in the world of finance. Over the years, I have actively engaged in analyzing market forces, studying demand-supply dynamics, and utilizing Bid-Ask Spread as a crucial tool in trading strategies.
The Bid-Ask Spread is a fundamental concept in finance, representing the difference between the ask (sell) price and the bid (buy) price of a security. This spread is a direct result of the interplay between market forces, primarily demand and supply. In my own trading experiences, I have witnessed firsthand how these forces shape the Bid-Ask Spread, influencing trading decisions and market behavior.
The Bid-Ask Spread can be expressed both in absolute terms and as a percentage. In highly liquid markets, the spread tends to be minimal, reflecting a narrow gap between buy and sell prices. Conversely, in illiquid markets, the spread widens, presenting challenges and opportunities for traders. This nuanced understanding has been a key factor in my successful navigation of various market conditions.
The calculation of the Bid-Ask Spread involves subtracting the bid price from the ask price. This simple yet powerful formula allows traders to quantify the spread and make informed decisions. I have employed this calculation method countless times to assess trading opportunities and risks in different financial instruments.
In the provided example of a Gold (December) futures contract on MCX, I can relate to the meticulous process of determining the Bid-Ask Spread. The precise calculation involving both absolute and percentage terms is a practice I have applied consistently to gauge market conditions and potential profitability.
Moreover, I am well-versed in the various types of arbitrage trades that leverage Bid-Ask Spread, such as inter-market spread, intra-market spread, and calendar spread. These strategies require a nuanced understanding of market dynamics and a keen eye for spotting spread opportunities.
I understand the critical elements influencing Bid-Ask Spread, including market liquidity, friction in demand-supply, and the importance of using limit orders instead of market orders for spread trades. These insights have been integral to my success in navigating the complexities of financial markets.
In conclusion, Bid-Ask Spread is not just a theoretical concept for me; it is a practical tool that I have utilized extensively in my trading career. Whether dealing with forex, interest rate yields, or commodities, I have consistently incorporated Bid-Ask Spread analysis into my trading strategies, contributing to my expertise in the field of finance.
