Understanding The Bid Offer Spread

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The bid offer spread (bid-ask) is the difference between the bid and ask prices of financial instruments such as shares or options. The spread is created by limited buy and sell orders from different parties.

Market makers and other professional players establish bid and offer prices in order to create a market. The bid and ask price of one player is called a quote.

The spread is related to liquidity in the market, a highly liquid market has a low bid-offer spread. In an illiquid market with a high bid-offer spread, the limit of an additional order is of importance.

The bid-ask spread means extra costs for the investor who buys or sells. The spread (or part thereof) is incorporated as transaction costs in the price. The smaller the spread constitutes the difference between bid and ask price, which is more profitable for investors.

The bid-offer spread can be achieved by comparing different instruments. If no professional (automated) ratios exist in the market, the market maker or liquidity provider then orders the best bid-ask spread, which can be extremely wide.

A trader starting a transaction is regarded as demanding liquidity, while a counterparty typically satisfies that need by providing liquidity. To achieve their objectives those demanding liquidity place market orders and limit orders are in turn placed by the counterparty.

As a result, the provider of liquidity derives a payment towards the spread from the liquidity demander, thus completing the spread transaction (otherwise known as the round trip).

Although on the majority of exchanges which include the Australian Securities Exchange (ASE), designated liquidity suppliers do not exist, instead other traders tend to provide liquidity. Institutions and private persons are in a position to place limit orders on such exchanges.

When two rates are being compared called the interest rate spread, it can be distinguished by maturity or credit quality. The difference between long-and short-term rates is referred to as the slope of the yield. Usually, it involves a comparison of between 3-month and10-year-old interest rates.

The comparison of returns of the same maturity but different credit qualities is called a credit spread. It is usual for example, for a corporate bond not to indicate the absolute return, but rather the credit spread (excess return), and are largely riskier than government bonds considered to have a top credit rating.

In the technical language of futures trading, a spread constitutes a carefully planned combined futures business. This is characterized in that the individual elements bear the same, although generally consistent economic traits, but the least in one of their typical characteristics (such as in their term) differ clearly from each other.

When trading in warrants a distinction is made between the absolute and the homogenised spread. The former is the real difference between bid and ask price, which has a warrant.  However, to make the spreads of warrants with different ratios comparable, it is necessary to resolve this with the basic ratio. By dividing the absolute spreads, the ratio gives the homogenized spread.

 

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