The bid-ask spread is the financial difference between the highest price a buyer is willing to pay for a security and the lowest price a seller is willing to accept.
Market mechanics and liquidity
The bid price is the maximum amount a buyer will pay for a financial instrument, while the ask price is the minimum amount a seller will take. The gap between these two numbers is the spread. This spread is the primary transaction cost of trading. Market makers and brokers profit from this difference by consistently buying at the bid and selling at the ask. This difference compensates the market makers for the risk of holding the security on their books.
Liquidity dictates the width of the bid-ask spread. Securities with high trading volumes, such as major fiat currency pairs or shares of large international companies, have very narrow spreads. There is a constant flow of buyers and sellers for these assets. Assets with low liquidity, such as small-cap stocks or obscure derivatives, have wider spreads. Market makers demand a larger premium to handle illiquid assets because finding a willing counterparty takes more time.
This pricing mechanism operates on every financial exchange globally. Whether Elephants are trading equities in Frankfurt or bonds in Tokyo, they pay the spread. Traders placing market orders execute immediately at the current ask when buying and the current bid when selling. Traders using limit orders can specify their exact price, potentially narrowing the spread but risking that their order goes unfilled.
Example
An Elephant decides to invest in Savannah Agricultural Group, a company listed on a public stock exchange. The Elephant opens their brokerage platform and views the order book for the stock. The current bid price is 50.10 and the current ask price is 50.15.
If the Elephant wants to buy 100 shares immediately, they must pay the ask price of 50.15 per share. If another Elephant decides to sell 100 shares of the same stock at the exact same time using a market order, they receive the bid price of 50.10 per share. The difference is 0.05 per share. This 0.05 is the bid-ask spread, which goes to the market maker facilitating the trade for both Elephants.