A stock is displayed at $25. So what does one share cost? Possibly $25.03. And if you immediately sell it, perhaps you receive $24.97. Nothing dramatic happened to the underlying company. You encountered the bid-ask spread.
Every market needs buyers and sellers
At a given moment, potential buyers submit prices they are willing to pay.
Potential sellers submit prices they are willing to accept.
The highest current buying price is the bid.
The lowest current selling price is the ask.
The difference between them is the spread.
Suppose a stock shows: Bid: $49.98. Ask: $50.02. The spread is four cents.
Someone buying immediately may pay around the ask. Someone selling immediately may receive around the bid.
Even if the quoted market price appears to be $50, the investor cannot necessarily trade at that exact midpoint.
Why spreads become a cost
Imagine buying 1,000 shares at $10.05 while the bid is $9.95.
You immediately change your mind.
If nothing else in the market moves and you sell at $9.95, the round trip costs roughly $100.
The company did nothing.
The market did not crash.
The loss came from crossing the spread twice.
For a long-term investor trading a highly liquid ETF with a one-cent spread, this may be nearly irrelevant.
For frequent traders in illiquid securities, spread costs can accumulate quickly.
Liquidity usually narrows spreads
A highly liquid stock has many willing buyers and sellers.
Competition between market participants tends to push bids and asks closer together.
A thinly traded stock may have far fewer participants willing to transact.
That can produce a wider spread.
Liquidity can also disappear during periods of extreme market stress.
A security that usually trades smoothly may develop a wider spread when uncertainty rises and market makers become less willing to hold risk.
This is one reason transaction costs can become larger precisely when investors most urgently want to trade.
Percentage spread matters more than cents
A 10-cent spread sounds small.
Its importance depends on the stock price.
For a $500 stock, 10 cents represents only 0.02 percent.
For a $2 stock, the same 10 cents represents 5 percent.
Investors examining low-priced or thinly traded securities should therefore think in percentage terms.
Market orders can expose you to the spread
A market order prioritizes execution.
It generally tells the broker to execute at the best currently available prices.
In a very liquid market, the difference between the displayed quote and final execution may be tiny.
In a fast-moving or illiquid security, available shares can disappear quickly.
The investor may receive prices considerably different from the quote they saw moments earlier.
Limit orders provide more control over the acceptable execution price, although they may never execute.
There is always a tradeoff between certainty of execution and certainty of price.
Why this matters for financial literacy
Investing platforms have dramatically reduced visible trading commissions.
That has led some investors to describe trading as free.
Execution still has economic costs.
The spread is one of them.
Taxes can be another.
Fund expenses matter.
Behavioral mistakes can dwarf all of these.
A zero-dollar commission does not mean the economic cost of entering and exiting an investment is literally zero.
Whenever markets are involved, understanding the price you see is only the first step.
Sources
- U.S. Securities and Exchange Commission, Investor.gov, definition of bid price, ask price, and spread.