The Bid-Ask Spread
With an understanding of quotation types, you can now see how market maker quotes translate into the prices customers actually pay and receive.
Bid and Ask Defined
| Term | Definition | Who Uses It |
|---|---|---|
| Bid | The highest price a dealer will pay to buy a security | The customer who is selling receives the bid price |
| Ask (Offer) | The lowest price at which a dealer will sell a security | The customer who is buying pays the ask price |
| Spread | The difference between the bid and ask prices | Represents the dealer's profit on a round-trip transaction |
The golden rule for customers:
- A customer sells at the bid (lower price)
- A customer buys at the ask (higher price)
The spread compensates the market maker for the risk of holding inventory and providing liquidity.
Inside Market (NBBO)
- The National Best Bid and Offer (NBBO) represents the tightest spread available across all market centers
- The inside bid is the highest bid from any market maker or exchange
- The inside ask is the lowest ask from any market maker or exchange
- Regulation NMS (National Market System) requires broker-dealers to route orders to the venue offering the best price (the NBBO)
Example: If Market Maker A quotes 50.00 bid / 50.10 ask, and Market Maker B quotes 50.05 bid / 50.08 ask:
- Inside bid = 50.05 (highest bid, from B)
- Inside ask = 50.08 (lowest ask, from B)
- NBBO spread = $0.03
Exam Tip: Gotchas
The NBBO is the best available price across ALL market centers, not just one market maker's quote. Regulation NMS requires routing to the NBBO, not just to any available price. The flow: multiple market makers post quotes, the best bid and best ask form the NBBO, and Reg NMS requires orders be routed there.
Factors Affecting the Spread
| Factor | Effect on Spread |
|---|---|
| High volume/liquidity | Narrows the spread (more competition among market makers) |
| Low volume/illiquidity | Widens the spread (fewer participants, more risk for market makers) |
| Volatility | Widens the spread (increased risk of adverse price movement) |
| Large-cap stocks | Generally tighter spreads |
| Small-cap/penny stocks | Generally wider spreads |
The pattern: anything that increases risk or decreases competition among market makers widens the spread.
Exam Tip: Gotchas
Customers always get the worse side of the spread. If a customer is buying, they pay the ask (higher price). If selling, they receive the bid (lower price). The exam may present a market maker's quote and ask what price the customer receives. Remember: customer sells at bid, buys at ask. Also, a wide spread indicates low liquidity or high volatility, not necessarily market manipulation. If the exam describes a stock with a wide spread, look for clues about trading volume or market conditions before assuming wrongdoing.