The Bid-Ask Spread
The Spread is the difference between what you must pay to buy an asset (Ask) and what you get if you sell it (Bid). It effectively represents the Cost of Liquidity.
Measuring the Spread
1. Quoted Spread
The raw difference in price.
- Formula: Ask - Bid
- Example: Ask = 100.10, Bid = 100.00 -> Spread = 0.10.
2. Relative Spread (Percentage)
Useful for comparing stocks of different prices (e.g., MRF vs Yes Bank).
- Formula: (Ask - Bid) / MidPrice
- Example: 0.10 / 100.05 = 0.1% (or 10 basis points).
3. Effective Spread
Measures the actual execution cost. Sometimes trades happen inside the spread (hidden liquidity).
- Formula: 2 * |TradePrice - MidPrice|
Why Does the Spread Exist? (The 3 Costs)
Why don't Market Makers just quote the same price for buying and selling?
1. Order Processing Cost
The fee for the exchange, clearing, and the electricity to run the servers. The MM must cover these fixed costs.
2. Inventory Cost (Inventory Risk)
If a MM buys stock from you at 100, they now hold "Inventory". If the market crashes to 90, they lose money. They charge a spread to compensate for this holding risk.
3. Adverse Selection Cost (Asymmetric Information)
This is the biggest component. The MM assumes that some traders know more than them (Information Asymmetry).
- If an informed trader buys, the price is likely going up. The MM sold low and lost.
- To protect against these "sharks", the MM widens the spread for everyone.
Liquidity Proxy: The Bid-Ask Spread is the most common measure of liquidity.
- Tight Spread (Low): High Liquidity (e.g., Apple, Reliance).
- Wide Spread (High): Low Liquidity (e.g., Penny stocks, obscure bonds).
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