Understanding is Bid-Ask Spread

What is bid-ask Spread?

A bid-ask “spread” is the difference between the highest price buyers are willing to pay (bid price) and the lowest price a seller is ready to take (asking price) for a given asset in the market. In traditional markets, the spread is managed often managed by market makers. In the crypto market, the spread comprises limited orders from buyers (bidders) and sellers (askers).

How does it work?

Like any market, there is always a negotiation between the buyers and sellers. The buyers will state how much they are willing to pay for an asset, known as the “bid.” The seller will state their asking price, known as the “ask.” When the prices are not in agreement, the difference between these prices is known as the bid-ask spread or just spread.

Liquidity & bid-ask spread

The size of the spread is mainly impacted by the amount of liquidity and trading volume of the given asset. Essentially, the higher the liquidity and trade volume, the lower the spread, and vice-versa. For example, a stock with high liquidity and trade volume has more participants in the market; thus, there is a higher chance of finding a matching bid and ask price.

Furthermore, fiat currencies are the most liquid assets; thus, you will find that the forex market tends to have smaller spreads. Similarly, heavily traded cryptocurrencies, stocks, and other assets have thinner spreads. Alternatively, small market cap assets tend to have wider spreads due to lower trading volumes.

Market and limit orders

• Market order: A trader can opt to place a market order which means that as a trader, you are willing to accept whatever price the market has to offer. Market orders are used when there is a need to buy or sell an asset immediately. The disadvantage here is that the trader will receive the highest possible price when buying or the lowest possible price when selling. Moreover, they are exposed to negative price slippage.

• Limit order: A trader can opt to set a limit order which enables them to place a bid or ask price of their choosing. Hence, the order will only be executed once the supply-demand forces have pushed the asset price to that level. Limit orders enable traders to buy or sell an asset at their preferred price and protect them against slippage. Although, limit orders are not ideal when wanting to buy or sell an asset immediately.

Depth Charts & bid-ask spread

Depth charts can be found on any exchange with a trading platform such as Binance, as seen in the image. Essentially, depth charts provide a graphical representation of an asset's order books. The quantity and price range of bids are represented in green, while the asks are represented in red. The gap between the two lines is the spread. 

Moreover, the spread of an asset is closely related to the amount of liquidity available. In trading charts, liquidity is usually represented by trading volume.