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The Importance of Bid-Ask Spread

Asset backed securities take a wide variety of formerly illiquid and directly-held assets and make them available to a wide range of investors. This investment vehicle minimizes risk and lowers costs because the pooling of assets is meant to make the securitization large enough to be economical and more diversified.

The bid-ask spread is one of the basic concepts of investing and business and will benefit you hugely if you learn it well! It also helps to gain an understanding of this powerful financial concept in order to negotiate the best price on your major purchases such as a new car.

The History of Bid-Ask Spreads

A market is where sellers and buyers meet to conduct transactions. From the time of the earliest humans, professional traders gathered in a location, such as a town market or bazaar, to conduct the trading of goods they had gathered or created.

Modern financial markets developed in much the some way. Traders gathered in markets and exchanged promises and financial claims. The coffee houses of London and Amsterdam were some of the first formal stock markets. Maritime insurers would gather to provide insurance for ships and cargo. Investors could finance commercial ships or even privateers like Francis Drake for a share of the profits.

Whether the market is an “open outcry” market like an old stock exchange or an electronic market, the concept of “bid-ask spread” is very important.

Understanding Bid-Ask Spread

The “bid” is the price that a buyer is willing to pay for a share or product. He places this bid to inform sellers of the price that he is willing to pay. This reflects the value that he expects to get from the transaction.

The “ask” or “offer” is the price that a seller sets and is the price that the seller believes he can get for the product.

The “bid-ask spread” is the difference between the buyer’s price and the seller’s price. In the context of bonds this is sometimes called the “price spread”, since many bonds are traded on their yield.

Spreads and Markets

If the prices are very close to each other, this means that both buyer and seller have a fairly similar opinion of the value of whatever is being sold.

A very small bid-ask spread indicates that the market is very efficient and both sides of the market have similar information or motivation. This is called a very “liquid” market, especially if there is considerable volume offered on both the bid and ask or on “either side of the market”.

Now consider a very wide bid-ask spread. This indicates a big difference of opinion between buyers and sellers. It could also indicate a market without much volume.

Market Makers and Liquidity

To increase the number of transactions in a market and increase “liquidity”, markets often appoint a “specialist” and “market maker” in a particular stock or bond. The role of the market maker is to facilitate transactions. If there is no bid, a market maker will supply a bid. If there is no offer, the market maker will supply an offer. If the market maker is “both sides” of the market, supplying both the bid price and ask price, this is called “making a market”.

For example, if a stock has been trading at $20, a market maker might place an offer of $20.10 and a bid of $19.90. He would be said to be “calling a market” of $19.90/$20.10. The trading point of $20 would be said to be the “mid-market price”.

Note that anyone needing to buy this stock would have to pay $20.10. Anyone wishing to sell would have to sell at $19.90. Who gets the difference?
The market maker, of course. The $.20 or 1% of price represents the profit the market maker gets for buying at the bid of $19.90 and selling at the offer of $20.10. This might seem unfair to the uninitiated, but it is how liquidity is provided to the market. The market maker assumes the risk that a buyer won’t show up for the stock he has bought. If so, the market maker has a “position” in the stock that comprises his “inventory”.

This is the way that liquidity is provided to a financial market.

The more illiquid the stock, the wider the bid-ask spread. This gives more compensation that the market maker for risking his capital.

Consumer Markets and Bid-Ask Spread

The concept of bid-ask spread can be applied to any market from souvenirs on a beach to buying a car. With a car, the bid is indicated by the price the buyer is willing to pay and the offer is the price at which the automobile dealer lists the car for sale.

Let’s consider the position of the automobile dealer and the car buyer. The buyer wants to pay as little as possible but the dealer has to cover his costs. The dealer advertises the “Manufacturer’s Suggested Retail Price” or MSRP. Most buyers pay below this level as automobile dealers compete. What should the dealer consider as the lowest price at which he can sell the car? Well, dealers are all invoiced the same price for a car by the manufacturers. This is called “Dealer’s Cost”. The difference between the MSRP and Dealer’s Cost is the bid-ask spread and the potential profit of the dealer.

All the buyer knows is the MSRP. How can she find out what the dealer cost is? Luckily, there are several sources for this, such as Consumers Reports or Edmunds.com from which a buyer can purchase a report that includes dealer cost. Armed with this information, the buyer can negotiate a better deal.

Sometimes a buyer can purchase a car below dealer cost. How could this be? If a dealership does not sell a car, it can’t exploit the possibility of servicing costs for the car. Given that cars now last a very long time, servicing is becoming a much bigger part of dealer profits. The dealers also know that if they sell a car, they can potentially get the buyer to sign up for “high margin” and very profitable services like rust proofing or an extended warranty. If the buyer buys winter car mats or other accessories from the dealer, these also add to the overall profit of the dealer and offset any loss on the actual car sale.