Bid-Ask Spread

The bid-ask spread is the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask or offer). This spread represents a market maker's profit and reflects market liquidity and trading costs. Understanding how bid-ask spreads work is essential for recognizing how market makers earn compensation and how transaction costs affect investors.

Core Concepts

The Bid Price

The bid price is the highest price a market maker is willing to pay to buy a security from an investor. When you see a bid price quoted, this is what you will receive if you are selling shares. The bid represents the market maker's buying interest and is always lower than the ask price. For example, if a stock has a bid of $50.00, the market maker will purchase shares from you at $50.00 per share.

When to Use This

• When an exam question asks what price an investor receives when selling securities to a market maker
• When determining which side of the spread applies to a customer liquidating a position
• When calculating the proceeds a customer receives from selling shares (multiply shares × bid price, then subtract commissions if applicable)
• When a question contrasts what a customer pays versus what they receive in a transaction

The Ask (Offer) Price

The ask price (also called the offer price) is the lowest price at which a market maker is willing to sell a security to an investor. When you are buying shares, you pay the ask price. The ask is always higher than the bid. For example, if a stock has an ask of $50.50, you will pay $50.50 per share when purchasing from the market maker.

When to Use This

• When an exam question asks what price an investor pays when buying securities from a market maker
• When determining the cost basis for a customer establishing a new position
• When calculating total investment required (multiply shares × ask price, then add commissions if applicable)
• When a question involves a customer entering the market as a purchaser

The Spread Itself

The spread is calculated as: Ask Price - Bid Price. This difference is the market maker's gross profit on a round-trip transaction (buying from one customer and selling to another). A stock quoted at $50.00 bid and $50.50 ask has a spread of $0.50. Market makers earn this spread as compensation for providing liquidity and taking on inventory risk.

Key facts about the spread:

• The spread is the market maker's compensation for facilitating trades
• Narrower spreads indicate higher liquidity and more competitive markets
• Wider spreads occur in less liquid securities or during volatile market conditions
• The spread represents a transaction cost to investors-they lose the spread amount when buying and immediately selling
• The spread can be expressed in dollar terms ($0.50) or as a percentage of the bid price

When to Use This

• When an exam question asks to calculate a market maker's gross profit or compensation
• When determining the immediate loss an investor faces from a round-trip transaction (buy then immediately sell)
• When comparing liquidity between two securities (narrower spread = more liquid)
• When a question asks about the cost of immediacy or market maker services

Market Maker Role in the Spread

Market makers maintain continuous two-sided markets by quoting both a bid and an ask price. They stand ready to buy at the bid and sell at the ask, providing liquidity to the market. Market makers profit from the spread rather than from directional price movements. They manage inventory risk by adjusting their quotes based on supply and demand.

Market maker obligations and practices:

• Must publish firm quotes-prices at which they will actually trade
• Must honor their quoted prices for at least the minimum quantity (typically 100 shares for stocks)
• Earn the spread as their primary compensation, not commissions
• May widen spreads during high volatility or low liquidity conditions
• Act as principals, buying into and selling from their own inventory

When to Use This

• When an exam question asks how market makers are compensated (the spread, not commissions)
• When distinguishing between market makers (principals) and brokers (agents who earn commissions)
• When a scenario involves who provides liquidity or maintains orderly markets
• When comparing compensation methods across different market participants

Factors Affecting Spread Width

Several factors influence how wide or narrow the bid-ask spread is for a particular security. Highly liquid securities like large-cap stocks typically have narrow spreads (often just $0.01), while illiquid securities like small-cap stocks or bonds may have wide spreads. Volatility also impacts spreads-higher volatility increases market maker risk, leading to wider spreads.

Factors that widen spreads:

• Lower trading volume (less liquidity)
• Higher price volatility (increased risk for market makers)
• Less competitive markets (fewer market makers)
• Larger position sizes (harder to execute without moving the market)
• After-hours trading (reduced liquidity outside regular market hours)

Factors that narrow spreads:

• High trading volume (greater liquidity)
• Stable prices (lower risk)
• More market makers competing (increased competition)
• Large-cap, actively traded securities
• During regular market hours with maximum participation

When to Use This

• When comparing spreads between two securities and identifying which is more liquid
• When a question asks why a particular security has a wide or narrow spread
• When determining the relationship between volatility and transaction costs
• When evaluating the impact of market conditions on trading costs

Inside Market and NBBO

The inside market (or National Best Bid and Offer, NBBO) represents the highest bid price and the lowest ask price available across all market makers and exchanges. If one market maker quotes $50.00 bid/$50.60 ask and another quotes $50.10 bid/$50.50 ask, the inside market is $50.10 bid/$50.50 ask-taking the best available prices for investors. Broker-dealers are required to execute customer orders at the NBBO or better.

When to Use This

• When a question presents multiple market maker quotes and asks which prices apply to customer orders
• When determining the best execution obligation of broker-dealers
• When calculating the narrowest available spread in a multi-market scenario
• When a scenario involves regulatory requirements for order execution

Comparison: Market Participants and the Spread

Percentage Spread Calculation

The spread can be expressed as a percentage of the bid price using the formula:

For example, if a security is quoted $40.00 bid and $40.80 ask:

Spread \% = \(\frac{40.80 - 40.00}{40.00}\) × 100 = \(\frac{0.80}{40.00}\) × 100 = 2%

This percentage helps compare spreads across securities with different price levels. A $0.50 spread means more for a $10 stock (5%) than for a $100 stock (0.5%).

When to Use This

• When an exam question asks to calculate the spread as a percentage
• When comparing relative spreads between securities at different price points
• When determining which security has a proportionally larger transaction cost
• When evaluating cost efficiency across different securities

Commonly Tested Scenarios / Pitfalls

1. Scenario: A question asks what price a customer receives when selling 100 shares of stock quoted at $25.00 bid / $25.25 ask.

Correct Approach: The customer receives the bid price of $25.00 per share, for total proceeds of $2,500 (before any commissions). Sellers always receive the bid price because that's what the market maker is willing to pay.

Check first: Identify whether the customer is buying or selling. Selling = bid price; buying = ask price. This is the single most important distinction.

Do NOT do first: Do not use the ask price for a seller or assume the customer gets the midpoint. Students often confuse which price applies to which side of the transaction.

Why other options are wrong: The ask price ($25.25) is what buyers pay, not what sellers receive. The midpoint ($25.125) is not used for actual transactions-customers always transact at one end of the spread, never in the middle.

2. Scenario: A question asks how a market maker is compensated for providing liquidity in a security quoted $50.00 bid / $50.40 ask.

Correct Approach: The market maker earns the $0.40 spread as compensation. When buying from one customer at $50.00 and selling to another at $50.40, the market maker profits $0.40 per share.

Check first: Confirm the question asks about a market maker acting as principal, not a broker acting as agent. Principals earn spreads; agents earn commissions.

Do NOT do first: Do not say the market maker earns a commission. Market makers act as principals and earn the spread, not commissions. Brokers (agents) earn commissions.

Why other options are wrong: Commission-based compensation applies to agents, not principals. The bid or ask price alone is not the market maker's compensation-only the difference between them is profit. The full transaction value is not compensation; it's just the price paid or received.

3. Scenario: A question presents two securities: Stock A quoted $100.00 bid / $100.05 ask and Stock B quoted $10.00 bid / $10.50 ask. It asks which has the more liquid market.

Correct Approach: Stock A is more liquid. The spread is $0.05 (0.05% of bid), while Stock B's spread is $0.50 (5% of bid). Narrower spreads indicate higher liquidity and lower transaction costs.

Check first: Calculate the spread as a percentage of the bid price to compare securities at different price levels fairly. Absolute dollar spreads can be misleading when prices differ significantly.

Do NOT do first: Do not compare only the dollar amounts without considering the percentage. A $0.50 spread seems larger than $0.05, but relative to price, Stock B's spread is proportionally much wider.

Why other options are wrong: Stock B's wider percentage spread indicates lower liquidity, not higher. Higher-priced stocks don't automatically have better liquidity-the spread relative to price matters. Using only absolute dollar values ignores the price context necessary for fair comparison.

4. Scenario: A customer buys 200 shares at $30.10 (ask price) and immediately sells them at $30.00 (bid price). The question asks about the loss.

Correct Approach: The customer loses $0.10 per share × 200 shares = $20.00 due to the bid-ask spread alone (excluding commissions). This loss reflects the transaction cost of the spread.

Check first: Identify that the customer is making a round-trip transaction (buy then sell), which means paying the ask and receiving the bid, thus losing the full spread amount.

Do NOT do first: Do not assume the customer breaks even or only pays commissions. The spread itself is a transaction cost separate from any commissions, and it's realized immediately in a round-trip.

Why other options are wrong: The customer does not profit-they lose money immediately due to the spread. The loss is not $0 even if no commissions are charged because the spread is a real cost. The ask price is not the same as the bid price, so there is always a loss equal to the spread in an immediate round-trip.

5. Scenario: Multiple market makers quote different prices for the same stock: MM1 quotes $25.10 bid / $25.30 ask; MM2 quotes $25.15 bid / $25.28 ask. A question asks what prices must be used for customer orders.

Correct Approach: The NBBO (inside market) is $25.15 bid (highest bid) / $25.28 ask (lowest ask). Customer orders must be executed at these prices or better, combining the best available bid and ask from all market makers.

Check first: Identify the highest bid across all quotes and the lowest ask across all quotes. These form the inside market, not the quotes from a single market maker.

Do NOT do first: Do not use all quotes from a single market maker. The best execution obligation requires using the best bid from one source and the best ask from another if they come from different market makers.

Why other options are wrong: Using MM1's ask ($25.30) when MM2 offers $25.28 violates best execution. Using MM1's bid ($25.10) when MM2 bids $25.15 gives customers worse prices. Averaging quotes or using midpoints is not how actual executions occur-customers get the best available bid or ask in the market.

Step-by-Step Procedures or Methods

Task: Calculate the dollar spread and percentage spread for a quoted security

1. Identify the bid price (what the market maker pays to buy)
2. Identify the ask price (what the market maker charges to sell)
3. Calculate the dollar spread: Ask Price - Bid Price
4. Calculate the percentage spread: \(\frac{\text{Ask Price} - \text{Bid Price}}{\text{Bid Price}}\) × 100
5. Verify that the ask is always higher than the bid; if not, recheck your identification

Task: Determine a customer's total cost when buying or proceeds when selling

1. Identify whether the customer is buying (pays ask) or selling (receives bid)
2. If buying: multiply number of shares × ask price
3. If selling: multiply number of shares × bid price
4. Add commissions if the transaction is through a broker acting as agent (commissions are stated separately from principal markups)
5. State the total cost (if buying) or total proceeds (if selling)

Task: Identify the NBBO (inside market) from multiple market maker quotes

1. List all bid prices from all market makers
2. Select the highest bid price-this is the inside bid
3. List all ask prices from all market makers
4. Select the lowest ask price-this is the inside ask
5. The NBBO is the combination of the highest bid and lowest ask, even if they come from different market makers

Practice Questions

Q1: A market maker quotes a stock at $42.00 bid and $42.50 ask. If a customer sells 300 shares to this market maker, what proceeds does the customer receive before commissions?
(a) $12,600
(b) $12,750
(c) $12,675
(d) $13,050

Ans: (a)
When a customer sells to a market maker, they receive the bid price. 300 shares × $42.00 bid = $12,600. Option (b) incorrectly uses the ask price ($42.50 × 300 = $12,750), which is what buyers pay. Option (c) uses an average ($42.25 × 300), which is not how transactions work. Option (d) uses an incorrect calculation.

Q2: How does a market maker acting as a principal earn compensation?
(a) By charging a commission on each trade
(b) By earning the difference between the bid and ask prices
(c) By receiving a management fee from issuers
(d) By collecting interest on margin loans

Ans: (b)
Market makers acting as principals earn the bid-ask spread-they buy at the bid and sell at the ask, profiting from the difference. Option (a) describes broker compensation (agents, not principals). Option (c) is not a market maker function. Option (d) relates to margin lending, not market making activities.

Q3: Stock X is quoted $80.00 bid / $80.20 ask. Stock Y is quoted $20.00 bid / $20.20 ask. Which statement is correct regarding their spreads?
(a) Stock X has a wider spread than Stock Y
(b) Stock Y has a wider percentage spread than Stock X
(c) Both stocks have equally liquid markets
(d) Stock X is less liquid than Stock Y

Ans: (b)
Both have $0.20 dollar spreads, but Stock Y's spread is 1% of its bid ($0.20/$20.00), while Stock X's spread is only 0.25% ($0.20/$80.00). Higher percentage spreads indicate lower liquidity, so Stock Y is less liquid. Options (a) and (c) ignore the percentage calculation needed for fair comparison. Option (d) is backwards-Stock X has better liquidity due to its narrower percentage spread.

Q4: Three market makers quote the same stock: MM1 quotes $30.05 bid / $30.25 ask; MM2 quotes $30.10 bid / $30.22 ask; MM3 quotes $30.08 bid / $30.20 ask. What is the NBBO?
(a) $30.05 bid / $30.20 ask
(b) $30.10 bid / $30.20 ask
(c) $30.08 bid / $30.22 ask
(d) $30.10 bid / $30.25 ask

Ans: (b)
The NBBO takes the highest bid ($30.10 from MM2) and the lowest ask ($30.20 from MM3). Option (a) uses the lowest bid instead of highest. Option (c) uses MM3's complete quote rather than the best bid and best ask from different sources. Option (d) uses the highest ask instead of lowest.

Q5: A customer buys 100 shares at $55.40 and immediately sells them at $55.10. Excluding commissions, what is the customer's loss?
(a) $0 (break-even)
(b) $15
(c) $30
(d) $55

Ans: (c)
The customer pays the ask ($55.40) when buying and receives the bid ($55.10) when selling, losing the $0.30 spread per share. 100 shares × $0.30 = $30 loss. Option (a) ignores the spread cost. Options (b) and (d) use incorrect calculations that don't reflect the actual spread multiplied by share quantity.

Q6: Which factor would most likely cause a market maker to widen the bid-ask spread?
(a) Increased trading volume in the security
(b) Lower price volatility
(c) Decreased liquidity in the security
(d) More competing market makers entering the market

Ans: (c)
Decreased liquidity increases risk for market makers, leading them to widen spreads to compensate for harder-to-manage inventory. Option (a) would narrow spreads by increasing liquidity. Option (b) reduces risk, which typically narrows spreads. Option (d) increases competition, which generally tightens spreads as market makers compete for order flow.

Quick Review

• Bid price: what the market maker pays when buying from customers (what sellers receive)
• Ask (offer) price: what the market maker charges when selling to customers (what buyers pay)
• Spread calculation: Ask Price - Bid Price = Dollar Spread; divide by bid and multiply by 100 for percentage
• Market makers earn the spread as principals; brokers earn commissions as agents
• Narrow spreads indicate high liquidity, low volatility, and competitive markets
• Wide spreads occur with low volume, high volatility, and fewer market makers
• NBBO (inside market): highest bid and lowest ask across all market makers-required for best execution
• Round-trip loss: buying then immediately selling costs the full spread (customer pays ask, receives bid)
• Percentage spreads provide fair comparison across securities at different price levels
• Customers always transact at bid or ask-never at the midpoint or an average of quotes