It’s been a while since I’ve done an investing 101 article, so I’m overdue. In this post, we’ll cover an important investing component: bid-ask spread. May sound boring, but the knowledge gained could save you hundreds, if not thousands, over your lifetime when applied.
What is Bid Price and Ask Price?
Before understanding the implications of the bid-ask spread, we must first define what bid price and ask price is. When you buy or sell a security (i.e. an ETF, bond, or stock trade), you will see two prices listed:
- Bid price: the highest price a buyer is willing to buy that security for.
- Ask price: the lowest price a seller is willing to sell that security for. Ask price is also referred to as “offer price”.
When a bid price overlaps an ask price, a trade is executed.
These prices change in real time during the trading day, often in milliseconds. And while they might seem trivial, they are not.
What is Bid-Ask Spread?
By definition, bid-ask spread is the difference in bid price and ask price. It is also referred to as the buy-sell spread. Bid ask-spread is calculated by subtracting the bid price from the ask price.
For example, if the bid price of Stock ABC is $11, and the ask price for the same stock is $11.05, then the bid-ask spread is $0.05 per share.
While $0.05 per share may seem like a trivial difference, it is not when you are trading thousands of shares. And that’s where liquidity and supply and demand come in to play.
Why is Bid-Ask Spread Important?
The more freely a security changes hands, the more “liquid” it is considered to be. Popular securities that trade in high volume are considered very liquid. And the more liquid a security is, the lower its bid-ask spread typically is. Popular securities that are highly liquid will often have a bid-ask spread that is less than a penny or two per share.
Where bid ask spread can become troublesome is in two scenarios:
- When a security that trades at low volumes: with less buyers and sellers in the market, the bid-ask spread is typically higher, which makes it harder for sellers to match buyers at desired prices. You will find this is lightly traded securities. It’s not unheard of to see a bid-ask spread of 1% or greater of a security’s price.
- When there is a big discrepancy between supply and demand: this can create a big difference in bid-ask spread. You typically see this in times of high volatility, with rapid gains or declines in share value.
These scenarios are worrisome because the bid-ask spread becomes a hidden trading cost that can total hundreds, if not thousands of dollars over the course of your lifetime. Even the wise process of rebalancing investments can become a money losing proposition each time you do it.
How to Defend Yourself from Bid-Ask Spread Losses with Limit Orders
If you could buy two identical mutual funds for the same price, but one had an expense ratio of 0.05% while the other had an expense ratio of 1.05%, which would you choose? The choice is obvious, right? Well, this is how one should think of bid-ask spread.
Most investors place their trades as “market order”, in which they do not select the price for which they are willing to buy or sell the security and it is purchased or sold at the prevailing market price (the ask price). However, by executing a market order, you are removing yourself from the negotiation and accepting the best available buy or sell price from another trader. You are accepting the bid-ask spread as it is when you place a market order. When you do this, the bid-ask spread winds up in the hands of those you have traded with instead of yours. In other words, you just padded the returns of someone else. If that isn’t enough to make you sick, I don’t know what is.
How can you prevent this from happening? Place only “limit orders”.
Limit orders are trades where you buy or sell a security at the price that you stipulate, or better (but never worse). For example, if you want to sell Stock XYZ shares for $10, but no less, you would place a sell limit order of $10. If you want to buy Stock XYZ for $9, but no more, you would place a buy limit order of $9. To do this, simply select “limit order” within your discount broker account when placing the order. Trailing stop loss orders, which I’ve highlight previously, are a type of limit order.
The downside of limit orders is that if there is no buyer at your sell price or seller at your buy price, then the order will not execute. If the market price moves away from your limit order price, you may have to cancel your order and create a new one.