A bid-ask spread can be defined as the difference between the highest amount of money a buyer is willing to pay for an asset or security and the lowest price that the seller of the same asset or security is willing to accept. As an investor looking to buy a stock, you pay the asking price while the one selling the stock accepts the bid price.
The bid-ask spread is therefore the measure of the flow of demand and supply for specific assets or securities. The bid represents demand while the asking price represents the supply. The Shifts in supply and demand for the assets is therefore reflected by the level of expansion between the bid price and the asking price of a particular asset.
As a stock trader, having a comprehensive understanding of the bid-ask spread for any particular stock is vital to your success as a trader because to a significant extent, the bid-ask spread becomes the de facto measure of the market liquidity for that particular stock.
Markets that are more liquid than others are reflected by their significantly low bid-ask spreads. In a typical stock market therefore, the price takers depend on market liquidity while the counterparties who are the market makers supply the liquidity by bidding on the stocks to pay their ask prices.
The bid-ask spread differs from one security to another as well as the exchange market.
The bid ask-spread can widen or shrink significantly depending on the state of the financial markets and the global economic conditions as well.
The bid-ask spread gap widens significantly at a time when there is illiquidity; a situation whereby, there are very few willing buyers for a specific security or asset compared to the number of willing sellers for that same security or asset.
Another instance when the bid ask-gap may widen is during tough economic times like the prevailing market conditions occasioned by the spread of the deadly novel coronavirus disease across the globe.
When there is market turmoil, very few traders are interested in buying stocks or paying asking prices beyond certain limits. At the same time, the sellers may not be willing to accept bid prices below certain set thresholds resulting in a state of illiquidity for that particular asset or security.