Bid-offer spread

The bid/offer spread (also known as bid/ask spread) for assets (such as stock, futures contracts, options, or currency pairs) is the difference between the price available for an immediate sale (bid) and an immediate purchase (ask). 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 USDZAR 6.456.55, or simply 6.4555. 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 wish means 10 pips.

Example: Stock spread

A customer might place a market order with a broker to buy 100 shares of Amalgamated Widgets. In response, the broker might attempt to buy 100 shares at $12.50 each, and then sell those shares to the customer at $12.60 each. In doing so, the broker would reap 100 times his $12.60 - $12.50 = $0.10 spread, or $10 on the trade. The broker knows that if he makes his spread larger, the customer might choose to instead find another broker with a lower spread. As a result, spreads are often only what the market will bear.

On United States stock exchanges, the minimum spread 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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