Bid ask

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The bid/offer spread (also known as bid/ask spread) for securities (such as stock, futures contracts, options, or currency pairs) is the difference between the price quoted by a market maker for an immediate sale (bid) and an immediate purchase (ask). The size of the bid-offer spread in a given commodity is a measure of the liquidity of the market and the size of the transaction cost. [1]

The trader initiating the transaction is said to demand liquidity, and the other party (counterparty) to the transaction supplies liquidity. Liquidity demanders place market orders and liquidity suppliers place limit orders. For a round trip (a purchase and sale together) the liquidity demander pays the spread and the liquidity supplier earns the spread. All limit orders outstanding at a given time (i.e., limit orders that have not been executed) are together called the Limit Order Book. In some markets such as NASDAQ, dealers supply liquidity. However, on most exchanges, such as the Australian Securities Exchange, there are no designated liquidity suppliers, and liquidity is supplied by other traders. On these exchanges, and even on NASDAQ, institutions and individuals can supply liquidity by placing limit orders.

Example: Currency spread

The exchange rate between the South African rand and the United States dollar might be 6.50 rand to the dollar. A person looking to convert rand into dollars might have to pay 6.55 rand for each dollar, while a person looking to convert dollars to rand might receive only 6.45 rand for each dollar he converts. It is usually written as USD/ZAR 6.45\6.55, or simply 6.45\55. 6.45 is the bid and 6.55 is the ask for 1 USD. (USD and ZAR are the International Organisation for Standardisation abbreviations ISO 4217 for the US and South African currency.) so for example the spread for the currencies pair is 6.55-6.45 = 0.10 Rand per Dollar. As a fraction of the mid-market rate of 6.50 the spread is 1/65 = 1.54%, or 154 basis points.

Example: Stock spread

On United States stock exchanges, the minimum spread (also known as the tick size) for many shares was 12.5 cents (one-eighth of a dollar) until 2001, when the exchanges converted from fractional to decimal pricing, enabling spreads as small as one cent. The change was mandated by the U.S. Securities and Exchange Commission in order to provide a fairer market for the individual investor.


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