Explained: Understanding The Bid-Ask Spread

Smaller Cap Trading

Explained: Understanding The Bid-Ask Spread

The bid-ask spread can quite easily catch out investors who are new to trading and attracted by the potential upside of certain smaller cap securities. Determining how to beat the spread and factoring it into your investment approach can help improve your returns considerably.

What is the difference between the bid and the ask price?

The bid price represents the maximum price a buyer is willing to pay for a particular security. The ask price – sometimes referred to as the offer price – is the minimum price a seller is willing to receive.

Do you buy at the bid or the ask price?

In other words, based on the above, you would buy shares in a security at the ask price and sell at the bid price. The difference between these two prices is referred to as the spread.

Why is there a difference in the bid and ask price?

The difference is down to the risk that Retail Service Providers (RSPs) take on board by guaranteeing the trading of securities up to certain limits by always being ready to both buy and sell a stock at all times. By being able to profit from the spread, these market makers provide liquidity to the market.

If everyone had Direct Market Access (DMA) and all securities were traded on the SETS order book, there wouldn’t actually be a bid-ask spread. Rather, there would simply be a gap in the price between that offered by the next most competitive seller and the next keenest buyer. Such a world, unfortunately, is off-limits to most of us and is the domain of institutional investors and highly experienced private traders.*

For the rest of us, those who execute trades via an online broker, we are left at the mercy of the quotes relayed to us by the selection of RSPs they poll for the current best price for a particular stock. This is where a lot investors become frustrated by the wide spreads they are forced to contend with.

Why does the spread differ vastly between different stocks?

The spread is a key indicator of the liquidity of the security. Securities with higher levels of liquidity tend to have narrower spreads, reflecting the presence of more active buyers and sellers, whilst those with lower levels of liquidity tend to have a larger spread. As such, smaller cap companies – the kind found on AIM – tend to have much large spreads than those listed on the Main Market.

A large spread is also indicative of the levels of risk RSPs take on by guaranteeing the trading of a particular stock. Therefore, during periods of high volatility it is common to see the bid-ask spread widen quite dramatically.

How do you calculate the bid-ask spread percentage?

In order to calculate the bid-ask spread percentage, simply divide the difference between the ask and bid price by the ask price.

(ask price – bid price) / ask price = spread percentage

For instance, if a company has an ask price of 10 pence and a bid price of 8 pence, then the spread percentage would be 20%.

(10 pence – 8 pence) / 10 pence = 20%

However, this isn’t actually the true cost to the investor. To earn a profit from this investment, the share price would need to increase by 25% just to break-even. To calculate the true cost to the investor, then, the bid price should actually be the denominator.

(10 pence – 8 pence) / 8 pence = 25%

How large can the spread percentage be?

As already averred to, the spread percentage for highly liquid securities can be incredibly low – for instance, at the time of writing, Barclays currently has a spread percentage of just 0.02%.

Compare this to certain smaller cap stocks, and the difference in trading environments becomes apparent – for instance, it’s not uncommon to see the spread percentage being as high as 20% – 40% during periods of high volatility.  

It is worth pointing out that market makers do actually have maximum spread requirements that they have to abide to. Unfortunately, though, these are only applicable to securities traded on SETS, and not those on the SETSqx trading system. Considering that 80% of AIM-listings currently use the SETSqx trading system, trying to beat the spread is a common challenge faced by investors that trade companies listed on the AIM Market.

Are there ways to beat the bid-ask spread?

The spread can quite easily catch out a lot of investors that are new to trading and attracted by the potential upside of certain smaller cap securities. Simply being aware of it and factoring it into the true cost of purchasing and selling your investments is an important first step.

Following this, ensuring that you do not trade during periods of volatility, when the spread percentage is typically at its highest, is also very important. During such periods, the tactics deployed by market makers can result in significant gains being lost by investors.

Other ways to protect yourself would be to ensure any target investment was traded via SETS and that the Exchange Market Size (EMS) was well within your trading threshold. Such things are good indicators as to the liquidity of particular securities.

Regardless, for any investor interested in trading AIM companies, the spread will at times be a price you will be forced to pay for the potential of your investment growing at a rate far beyond those companies listed on the Main Market. With proper research and the intention of holding on to your investment for a reasonable length of time, the spread that you are forced to initially accept could possibly pale in comparison to the price you eventually sell at.

*Credit to James Crux at Shares Magazine for this point well-made.

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