What are Bid-Ask Spreads? And How They are Like Buying a Second Hand Car

Posted by Andrew Gordon on March 19
used car sales.jpeg

To first understand what the bid-ask spread is we must understand what bids and asks are. A bid is the price someone is willing to pay for an ETF. An ask is what someone is willing to sell an ETF for, it is also commonly known as an offer.

There may be several bids at different prices, for example a bid for £99.80 and one for £99.95. The best bid is the most someone is willing to pay for it, in this example £99.95 is the best bid. There may be several asks (or offers) at different prices, for example an ask of £100.10 and one for £100.05. The best ask is the least someone is willing to sell for, in this example £100.05 is the best ask.

The spread is the difference between the best bid and the best ask. It is normally quoted in percentage terms. Another term to be aware of is the market’s fair value. This is what the market thinks that the ETF is worth. The market’s fair value of the ETF normally lies between the best bid and best ask. For simplicity sake and in the example below we will assume that the fair value is in the middle of the best bid and best ask.

The spread in notional (or £ amount) terms is the difference between the best bid and the best ask. To get it into percentage terms we just divide this number by the fair value of the ETF.

In the example below, we can see what the current market and spread looks like for a ETF.

2 - bid-ask spread ETF example.jpg

There is only one bid and one ask. The ETF’s fair value is £100.00. The bid is £99.95. This means there is someone willing to pay £99.95 for the ETF, they are happy to do this because they are paying £0.05 less that what its worth. The ask is £100.05. This means there is someone willing to sell the ETF for £100.05, they are happy to do this because they are selling it for £0.05 more that what it is worth. The spread is the difference between the bid and the ask. In notional terms it is £0.10 and in percentage terms it is 0.10%.

If someone wanted to go to the market now and buy the ETF they could buy it for £100.05. The costs associated with this transaction due to the bid-ask spread would be £0.05 or 0.05% (half the spread) in percentage terms. This is because you are paying slightly over what the ETF is currently worth.

If someone wanted to go to the market now and sell the ETF they could sell it for £99.95. The costs associated with this transaction due to the bid-ask spread would be £0.05 or 0.05% (half the spread) in percentage terms. This is because you are selling it for slightly under what the ETF is currently worth.

Used Car Dealer

It’s a similar situation to when you go to a used car dealer. One customer may come in and want to sell their car. From years of experience and using the year, make, model and condition of the car the dealer thinks the car is worth £5,000 so he says he will pay the customer £4,800 for the car. Another customer comes in the next day and wants to buy the same car. The dealer thinks the car is worth £5,000 so they say to this new customer they can buy the car for £5,200. In this example the fair value is £5,000. The bid is £4,800 and the ask is £5,200. As you can see from the diagram below the spread in this case would be 8%.

bid-ask spread Car example.jpg

The car dealer is always willing to buy the car for a little less than it is worth and sell it for a little more than it is worth. This is how they make their profits and don’t go out of business. Traders that provide the same function for ETFs and other securities are called market makers. They are called this because they are always willing to make markets in an ETF or security. i.e. always provide a bid and ask so that other people can come in and either buy or sell the ETF or security.

At Moola we always take the bid-ask spread into consideration when chosing what ETFs are in the portfolios. By using ETFs with lower bid-ask spreads it means that the cost of purchasing the ETFs is lower and these savings go directly into customer's portfolios.

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Written by Andrew Gordon

Andrew is the Head of Algorithmic Trading at Moola. He previously worked on the ETF Desk for three and half years at Susquehanna International Group, a global quantitative trading firm. Andrew has a degree in Finance from Queen’s University Belfast.

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