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Definition of 'Bid-ask Spread'


Definition: Bid-Ask Spread is typically the difference between ask (offer/sell) price and bid (purchase/buy) price of a security. Ask price is the value point at which the seller is ready to sell and bid price is the point at which a buyer is ready to buy. When the two value points match in a marketplace, i.e. when a buyer and a seller agree to the prices being offered by each other, a trade takes place. These prices are determined by two market forces -- demand and supply, and the gap between these two forces defines the spread between buy-sell prices. The larger the gap, the greater the spread! Bid-Ask Spread can be expressed in absolute as well as percentage terms. When the market is highly liquid, spread values can be very small, but when the market is illiquid or less liquid, they can be large.

Description: Calculation of Bid-Ask Spread:

Bid-Ask Spread (absolute) = Ask/Offer Price – Bid/Buy Price Bid-Ask Spread (%) = ((Ask/Offer Price- Bid/Buy Price) – Ask/Offer Price)*100

Example: Gold (December) futures contract on MCX has best buy price at Rs 26,473 and best sell price at Rs 26,478. So the Bid-Ask Spread is equal to (Rs 26,478-Rs 26,473) = Rs 5 and the percentage spread will be equal to ((5/26,478)*100) = 0.019% There can be various buyers and sellers in the market and they may be willing to buy/sell any security at different price points. So, all price points cannot be used to calculate Bid-Ask Spread. This can be calculated by using the lowest Ask Price (best sell price) and highest Bid Price (best buy price). The Bid-Ask Spread is one of the important trading points in the derivatives market and traders use it as an arbitrage tool to make little money by keeping a check on the ins and outs of Bid-Ask Spread.

Bid-Ask spread is used in following arbitrage trades:

1) Inter-market spread : When a trader buys the futures of a security having a particular expiry on one exchange and sells the same security contract with a near-expiry on another exchange,

2) Intra-market spread : When the contract of one security is bought and that of another security is sold on the same exchange e.g. gold and silver spread trade,

3) Calendar spread : When a security contract of one expiry date is bought and another contract of the same security with a different expiry date is sold on the same exchange.

Some of the important elements to Bid-Ask Spread: 1) The market for any security should be highly liquid, otherwise there may be no ideal exit point to book profit in a spread trade.

2) There should be some friction in demand-supply of that security, because that creates chances for a wider spread.

3) A trader should not use ‘market order’ for spread trade, otherwise the spread opportunity can be missed. It’s wise to use ‘limit order’ where the trader decides the entry point.

4) The range of a spread trade is relative to that particular security market, it’s not same for all.

5) Always check Bid-Ask Spread ins and outs, and look for spreads either in absolute or percentage terms for individual security. If it’s a margin trade, then use spread percentage.

6) Bid-Ask Spread trade involves a cost, as you are doing two trades simultaneously.

7) Bid-Ask Spread trades can be done in almost all kinds of securities, but they are quite popular in forex, interest rate yields and commodities.




Souce : Sasha Evdakov
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