What it is:
How it works (Example):
Let's assume you are watching Company XYZ's stock. If the bid price is $50 and the ask price is $51.50, then the bid-ask spread is $1.50. Typically, a trader or specialist on the floor of the New York Stock Exchange would quote the bid-ask spread as follows:
50-51-1/2 100x50 100,000
The last number (100,000) denotes the number of Company XYZ shares traded since the market opened. Note that online trading systems might refer to the bid-ask spread as "BxA."
There may be several bid prices and several ask prices for a security at any point in time. However, only the best bid (that is, the highest price offered for a security) and the best ask (that is, the lowest price asked for a security) are used to calculate the bid-ask spread.
Note that the number of shares wanted and the number of shares offered for sale may be different. This means that an investor may only be able to purchase 5,000 of a desired 10,000 XYZ Company shares at $51.50 if there are only 5,000 shares for sale at that price.
Why it Matters:
It is important to remember one key aspect of bid and ask prices: purchasers pay the ask price and sellers receive the bid price. This nuance is why securities dealers make a profit on bid-ask spreads. Their job is to buy stocks at the bid price and sell at the ask price. Thus, the size of the bid-ask spread is proportional to the size of the dealer's profit (although not all of the spread constitutes profit for the dealer, other fees are part of the spread). Dealer profit is also one reason illiquid or lightly traded stocks tend to have larger spreads than frequently traded stocks.
Many traders and analysts scrutinize patterns in bid-ask spreads to understand what prices trigger demand for both sellers and buyers. Other traders and analysts feel that the bid-ask spread itself has little predictive value.