The bid–ask spread and the market maker

◈ 5 cards

You buy at the ask and sell at the bid — read a quote, compute the spread in dollars and as a percentage of the midpoint, and see who earns it.

Reading a quote

A quote has two prices. The bid is the highest price anyone is currently willing to pay for the security; the ask (or offer) is the lowest price anyone is currently willing to sell at. The spread is the difference, and it is always the ask minus the bid — a positive number, because nobody offers to sell below what someone else will pay for long.

The rule the paper tests: an investor who wants to trade now buys at the ask and sells at the bid — the worse of the two prices each way. Whoever stands on the other side — a market maker quoting both prices, or a dealer trading from inventory — does the reverse: buys at the bid, sells at the ask, and keeps the difference.

Worked example — Tamarack Foods, 24.10 / 24.16

Tamarack Foods is quoted 24.10 bid / 24.16 ask.

$spread = 24.16 - 24.10 = $0.06$

As a fraction of the midpoint $\frac{24.16 + 24.10}{2} = 24.13$ :

$\frac{0.06}{24.13} = 0.002487 \approx 0.25 %$

In Excel, with bid in B2 and ask in C2: =C2-B2 and =(C2-B2)/((C2+B2)/2).

Renata buys 500 shares at market and sells them an hour later, the quote unchanged. She pays the ask, $24.16 \times 500 =$ 12,080, and receives the bid, $24.10 \times 500 =$ 12,050. Her round-trip spread cost is $0.06 \times 500 = * *$ 30** — =(C2-B2)*shares — before any commission, and before the price has moved at all. The market maker who took the other side of both trades earned that $30 for standing ready.

Why the spread exists

The market maker's job is immediacy: to be there when you want to trade, without your having to wait for another investor. The spread is the price of that service and the market maker's compensation for the risk of holding inventory that may fall. Liquid, heavily traded shares have spreads of a cent or two; thin stocks and most bonds have wider ones, because the risk of being stuck with inventory is larger. The percentage spread — spread over midpoint — is the comparable measure across securities of different prices.

A wider quote

Cobalt Ridge Mining is quoted 7.40 / 7.52. Spread $0.12; midpoint 7.46; percentage spread =0.12/7.46 = 0.016086, about 1.61 % — more than six times Tamarack's, on a stock a third of the price. A 1,000-share round trip costs $120 in spread. The dollar spread tells you little on its own; the percentage is what a portfolio manager compares.

The side rule, cold

Buy now → pay the ask. Sell now → receive the bid. The market maker → the opposite of you, both times. A limit order (Module 11) is the way to insist on a better price than the quote — at the cost of maybe not trading at all.