All you need to know about bid-ask spreads and its importance while trading

When you trade stocks the price / volume screen will show you the bid price and the ask price. The bid price shows the best price at which the other party is willing to buy the stock. That will be the best price at which the trader on the screen can sell the stock. The ask price shows the best price at which the other party will sell the stock. It is the best price at which the trader on the screen can buy the stock. The extent to which the ask price on the screen is greater than the bid price on the screen represents the bid-ask spread of the stock. Look at the bid-ask chart below.

Source: NSE

The yellow shaded portion in the above chart shows the bid price and the ask prices. There is also the bid quantity that you must consider. Note that the bid quantity or the ask quantity at any price is not the full picture of the volumes. A trader can put 10% of the order as visible and the balance 90% of the order as invisible order. That means, if the screen shows Sell quantity (ask quantity) at 2,756 shares for price Rs.925.50, then the actual volumes could be as high as 27,560 shares technically.

Breaking up the bid ask spread of a stock

In the above chart, the Buy price and the Buy quantity are also called the Bid Prices and the Bid quantity. This is the price and quantity that the market players are willing to buy at. When you sell shares, you sell at the best Buy Price (bid price). Assuming there are no invisible orders in the above case, if you put an order for selling 725 shares of RIL, then it will be executed as follows:

47 shares sale executed at Rs.925.25

666 shares sale executed at Rs.925.00

12 shares sale executed at Rs.924.90

Let us move to the other side of the trade. In the above chart, the Sell price and the Sell quantity are also called the Ask Price and the Ask quantity. This is the price and quantity that the market players are willing to sell at. When you buy shares, you buy at the best Sell Price (Ask price). Assuming there are no invisible orders in the above case, if you put an order for buying 280 shares of RIL, then it will be executed as follows:

77 shares buy executed at Rs.925.30

103 shares buy executed at Rs.925.35

100 shares buy executed at Rs.925.40

But what exactly is the bid ask spread and why is it important?

As stated earlier, the bid–ask spread is the extent to which the Best Sell Price (ask price) exceeds the Best Buy Price (bid price). In the above case, the best ask price is Rs.925.30 and the best bid price is Rs.925.25. The bid-ask spread will there be Rs.0.05 or 5 paisa. Normally, liquid stocks like RIL, SBI, and Tata Motors tend to normally quote at the minimum bid-ask spread of 5 paisa. But as we go towards less liquid stocks and especially small cap and mid cap stocks, the bid-ask spread can widen substantially. Let us now look at how to interpret the bid-ask spread as a trader.

• Bid ask spread is an important barometer of the liquidity of any stock. Normally, more liquid the stock, more actively it changes hands and finer the pricing. Highly liquid stocks that are part of the Nifty and Sensex have very low bid-ask spreads as they are sufficiently liquid.

• Bid ask spread is a measure of the trading risk of the stock. For example, the whole idea of executing a buy or order in the market is to get the stock as close to the best price as possible. Higher the bid ask spread, higher the risk in trading the stock and that imposes an indirect cost on trading. While spread cost is not directly measured like brokerage or STT, it does impose a steep cost over a longer period of time.

• Bid ask spread is a guide on the type of order to be placed. Normally, if the bid ask spreads are narrow you can get the best price with the market order itself. However, if the spreads are wider, then a limit order will be a better choice.

• Narrowing and widening of the bid-ask spread is an indication of the direction of the market movement. One can tweak trades accordingly.

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Disclaimer: The above opinion is that of Ms. Ruchit Jain (Equity Technical Analyst - Angel Broking) and is for reference only.