What is the bid-offer spread?
The bid-offer spread is how much it costs to buy and sell stuff. This stuff could be anything that people trade, like stocks, bonds, gold, Pokémon cards, you name it. But let’s focus on stocks to keep it simple.
The “bid” is how much someone will pay to buy the stock from you. The “offer” (sometimes called the “ask”) is how much they will sell the stock to you for. The offer price is always higher than the bid price.
Why aren’t the prices the same? Well, the guy in the middle has to make money somehow! That guy is called a dealer or market maker. His job is to connect buyers and sellers so trading can happen smoothly. The bid-offer spread is his profit.
An example of the bid-offer spread
Let’s say you want to buy a share of Noodle Co. stock. You look up the prices:
Bid: $10.00 Offer: $10.05
The bid-offer spread is $0.05. If you buy at $10.05 and immediately sell at $10.00, you’d lose $0.05 per share. That money goes to the dealer as his cut for making the trade happen.
Why the bid-offer spread matters
It’s a cost of trading
When you buy and sell stocks, the bid-offer spread acts like a fee. It’s not a separate charge, but it’s baked into the prices. The bigger the spread, the more it’ll cost you to trade.
Spreads are usually pretty small for popular stocks – we’re talking pennies. But they can get hefty for stuff that doesn’t trade a lot.
It measures liquidity
Liquidity just means how easy it is to trade something without the price moving a ton. The bid-offer spread tells you a lot about liquidity.
Tight spreads (like our $0.05 example) signal high liquidity. There’s not much difference between the buy and sell prices. You can move in and out of the stock easily.
Wide spreads mean low liquidity. The big gap between bid and offer shows that the market is thin. Not a lot of folks are trading. It’ll cost you more to buy and sell.
It reflects supply and demand
The bid represents demand – how much people want to buy. The offer represents supply – how much people want to sell.
When demand outweighs supply, the bid rises closer to the offer. Buyers are eager and willing to pay up. When supply swamps demand, the opposite happens. Sellers get antsy and more flexible on price.
So the bid-offer spread is a quick window into the balance (or imbalance) between buyers and sellers. Dealers are always adjusting their bids and offers based on which way the wind is blowing.
The dealer’s role
They provide liquidity
Dealers are the lifeblood of markets. Without them, buyers and sellers would have a hard time finding each other. Trades would be few and far between.
By always being willing to buy and sell, dealers keep markets humming. They ensure you can trade when you want at a fair price. That’s what liquidity is all about.
They take on risk
Dealers don’t just kick back and collect that bid-offer spread, though. They’re taking on risk.
See, the dealer buys stock without knowing if someone will buy it from him at a higher price. He could get stuck holding the bag. Same goes when he sells stock he doesn’t have yet. He’s betting he can get it for cheaper than he sold it.
If prices move against the dealer, he bleeds money. The bid-offer spread compensates him for putting his neck on the line. It’s his risk premium.
They keep markets orderly
Dealers help make stock prices move in baby steps rather than giant leaps. They’re like market shock absorbers.
When there’s a sudden surge of buying or selling, dealers are on the front lines. They take the other side of lopsided trades, helping offset the imbalance. Their actions have a smoothing effect on prices.
It doesn’t always work perfectly (just look at the crazy market crashes we’ve had). But dealers definitely help tame volatility. They’re a stabilizing force.
The bid-offer spread and you
Shop around
Not all dealers charge the same spreads, even for the same stock. It’s worth comparing a few to see who’s giving you the best deal.
Look at both the bid and offer prices. Don’t just fixate on the spread. After all, Dealer A could have a tighter spread than Dealer B, but worse prices overall. The total cost is what counts.
Watch the spread
There’s lots of stuff you can’t control when you invest. The bid-offer spread is one of them. It’s a cost of doing business – you’re always gonna pay it.
But you can keep an eye on it. Avoid trading stuff with monster-sized spreads. You’ll save on trading costs in the long run.
Also, check the spread before you place each trade. Make sure it hasn’t suddenly widened for some reason. A big spread could mean there’s funny business going on.
Think long-term
The bid-offer spread stings the most if you’re trading a ton. Every time you buy and sell, you’re coughing up that spread to the dealer. It adds up quick.
But if you’re a buy-and-hold type, the spread won’t bug you as much. You’ll pay it when you get in and again when you cash out, but that could be years apart. As a percentage of your total profit (knock on wood), the spread might look like peanuts.
So if you’re gonna let dealer spreads influence your strategy, think about your time horizon. They matter more for short-term traders than long-term investors.
