The bid-ask spread is the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept.
Basic mechanics
If the bid is 99 and the ask is 101, the spread is 2. The spread compensates dealers or market makers for providing immediacy and taking on inventory and information risk.
More generally, spreads tend to be:
- narrower in liquid, low-risk markets,
- wider when trading is thin, volatility is high, or information is unevenly distributed.
Why the spread matters
The spread is a transaction cost. A trader who buys at the ask and sells immediately at the bid loses the spread even if the fundamental value of the asset has not changed.
This is why economists and market practitioners use the spread as an indicator of:
- liquidity,
- market depth,
- market stress,
- trading frictions.
Practical example
Government bonds or heavily traded large-cap stocks often have very small spreads because many buyers and sellers compete to trade them. Risky or illiquid assets can have much wider spreads because market makers demand more compensation for holding them.
Knowledge Check
### What does the bid-ask spread measure?
- [x] The gap between the highest bid and the lowest ask
- [ ] The average dividend yield
- [ ] The difference between profit and cost
- [ ] The slope of a regression line
> **Explanation:** The spread is the quoted buying-selling gap in a market at a point in time.
### Why do wider spreads often appear in stressed or illiquid markets?
- [x] Because dealers need more compensation for risk and uncertainty
- [ ] Because buyers stop caring about price
- [ ] Because markets become perfectly competitive
- [ ] Because volatility always lowers trading costs
> **Explanation:** Thin trading and uncertainty make it riskier to supply liquidity, so the price gap widens.
### Why is the spread an important trading cost?
- [x] Because buying at the ask and selling at the bid immediately locks in a loss equal to the spread
- [ ] Because it applies only to taxes
- [ ] Because it matters only for government bonds
- [ ] Because it is unrelated to liquidity
> **Explanation:** The spread is a built-in round-trip cost even before commissions or other fees are added.