The cost of investing has come down dramatically over time, as commissions have fallen so far that it's easy to buy and sell shares cheaply. Yet there are other trading costs beyond brokerage commissions, and the bid-ask spread is one of the most important that frequent traders have to take into consideration. Knowing the bid-ask spread percentage for the stocks you intend to trade will help you understand the true costs of the purchases and sales you make in your portfolio.
How the bid-ask spread works
Stock exchanges work by bringing together buyers and sellers. When two parties agree on a price, a trade goes through. To facilitate trades, financial institutions take on the role as market-makers for stocks, posting two different prices, a lower one at which they'd be willing to buy the stock, and a higher one at which they'd be willing to sell it. The highest price at which a market-maker will buy the stock is known as the bid, while the lowest price among those willing to sell is called the ask. The interval between those two prices is the bid-ask spread.
For the most liquid stocks, the bid-ask spread can be extremely small. For example, Apple shares typically trade with a bid-ask spread of just a single penny per share. However, for stocks that don't have as much trading volume, you'll typically see wider bid-ask spreads of a nickel or more per share.
Since you'll never buy and sell a stock at exactly the same moment, it can be hard to understand the impact that the bid-ask spread has. One way to think about it, though, is to assume that the real current value of the stock is halfway between the bid and the ask. If you buy 100 shares of a stock with a spread of a penny, then the added cost from the spread will be 100 x $0.01 x 1/2, or $0.50. For a larger transaction of 1,000 shares on a stock with a bid-ask spread of a dime, the cost is much higher: 1,000 x $0.10 x 1/2, or $50.
Why a percentage calculation is important
Notice that the true cost of the bid-ask spread doesn't have anything to do with the price of the stock but rather only with the number of shares and the size of the spread. What that means is that a penny-per-share bid-ask spread on a $10 stock will have a much larger relative cost than the same spread on a $100 stock.
To calculate the bid-ask spread percentage, simply take the bid-ask spread and divide it by the sale price. For instance, a $100 stock with a spread of a penny will have a spread percentage of $0.01 / $100 = 0.01%, while a $10 stock with a spread of a dime will have a spread percentage of $0.10 / $10 = 1%.
Many investors never notice the bid-ask spread, but it's a real cost that you'll need to overcome in order to earn a profit on your investment. The bid-ask spread percentage gives a good indication of how liquid a stock is and how much danger there is in using market orders to buy and sell shares for your portfolio.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at email@example.com. Thanks -- and Fool on!
The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.