Bid/ask spread

In a liquid market, such as those for stocks and bonds, there are many buyers and sellers willing to pay and accept different prices. An offer from a potential buyer for an item is called a bid. An offer from a potential seller is called an ask. The market price is the price of the last sale, when a bid equaled an ask. At any moment, the difference between the highest bid and the lowest ask is called the bid/ask spread. For example, if the most eager buyer is willing to pay $20.50 for a share of Microsoft, and the most eager seller is willing to accept $20.52, then the bid/ask spread is $0.02.

An investor who decides to place a market order for Microsoft will pay the ask, $20.52 in this example. Let's say that a week later, the stock's bid and ask prices have returned to the same levels, and the investor decides to sell their shares, again placing a market order. They will receive the bid price, which is $20.50. Thus, even though the market has not changed, the investor will have paid $0.02 per share in bid/ask spread. This expense is in addition to any commissions the investor may pay their broker.

Foreign exchange markets are the most liquid, and often have bid/ask spreads of a hundredth of a cent. The municipal bond market is notoriously illiquid, and can have bid/ask spreads of several percent of the value of the bonds.

In less liquid markets like those for bonds, individuals may pay a higher bid/ask spread than institutions, which are able to negotiate more favorable terms with their higher volume.

Links

 * Google definitions
 * Bid/ask spreads for Vanguard ETFs