Bid-ask spread

At any moment there are two prices for a share or a contract, not one:

• the bid — the highest price a buyer is willing to pay;
• the ask — the lowest price a seller is willing to accept.

The ask is always above the bid. The difference is the bid-ask spread.

If you are in a hurry and use a market order, you buy at the ask and sell at the bid. Do both in quick succession and you lose the spread without the price having moved at all. The workbook calls this the transaction cost the market charges for the privilege of trading.

The spread is a cost you never see on a contract note. Chapter 6 lists it with impact cost as costs that are not actually paid but arise from market imperfections or lack of liquidity. The spread tends to be larger for illiquid stocks with less participation.

The spread measures the cost of a small trade. For a larger order, you exhaust the best bid or ask and move deeper into the book, so your cost rises. That extra degradation is measured by impact cost, calculated against the ideal price — the mid-point of the best bid and best ask.

The relationship, as the workbook puts it: impact cost is a measure of the cost incurred due to the bid-ask spread, and the larger the bid-ask spread, the larger the impact cost.

Who avoids it. Buyers who place limit orders instead of market orders, and sellers who do the same, need not cross the spread — at the price of possibly not being filled.

Bid-ask spread = Best ask − Best bid
Ideal price    = (Best bid + Best ask) / 2

1. Shares (Chapter 2). Best buy Rs 4.00, best sell Rs 4.50.

Spread = 4.50 − 4.00 = Rs 0.50
Buy 100 at 4.50, sell 100 at 4.00 → loss = 0.50 × 100 = Rs 50
Ideal price = (4.00 + 4.50) / 2 = Rs 4.25

Now try 3,000 shares. The sell order hits bids of 1,000 at 4.00, 1,000 at 3.90 and 1,000 at 3.80; the buy order takes 2,000 at 4.50 and 1,000 at 4.55. The cost is far more than the Rs 0.50 spread suggests — which is why the workbook says the spread conveys the cost for a small trade.

2. An option (Chapter 6). Best bid Rs 16.60, best ask Rs 16.80.

Spread = 16.80 − 16.60 = Rs 0.20

An investor who buys at 16.80 and squares off at once at 16.60 loses Rs 0.20. The workbook describes this as a loss of Rs 0.20 per lot; since option premiums are quoted per unit of the underlying, read it as Rs 0.20 per unit, so the rupee loss on a lot is 0.20 × the lot size (the example does not state one).

Chapter 2, section 2.4, introduces the bid-ask spread in the order-book example that leads into impact cost. Chapter 6, section 6.5 (Trading costs), classes it with impact cost as a cost not actually paid, arising from illiquidity, with the option order book above. A sample question at the end of Chapter 2 asks which cost is not paid but arises from lack of liquidity.

• Spread = ask − bid, and the ask is the higher number.
• The spread is the cost of a small trade. For large orders, impact cost is the right measure.
• It is not invoiced. Brokerage, STT and exchange charges are paid; the spread and impact cost are not, yet they are real costs.
• Wider spreads mean less liquidity, and larger impact cost.
• Market orders cross the spread; limit orders need not.
• The option example's "per lot" wording: the Rs 0.20 is per unit of premium; multiply by lot size for a lot.