Definition
The bid-ask spread is set by market makers who profit from the difference. Tight spreads (a few cents on major stocks) indicate deep liquidity and low trading friction. Wide spreads (10%+ on thinly-traded small-caps) signal illiquidity — traders pay a significant premium just to execute. Spreads widen during volatility (market makers demand more risk premium) and are wider outside regular market hours. For active traders, spreads are the largest non-commission cost — a 0.5% spread on 50 round trips per year = 25% drag. Buying at the ask and selling at the bid ('crossing the spread') is instantaneous but costly; using limit orders inside the spread gets better pricing but risks non-execution.
Example
SPY (S&P 500 ETF) typically shows bid 425.02 / ask 425.03 — a $0.01 (0.002%) spread. In contrast, a low-liquidity micro-cap might show bid $4.20 / ask $4.50 — a 7% spread. Round-trip on the micro-cap costs the trader 7% immediately.
Frequently Asked Questions
Why do spreads widen during volatility?
Market makers face higher inventory risk when prices move fast. They compensate by widening the spread to earn more per trade, offsetting the risk of holding positions that move against them.
Should I use market orders or limit orders?
Use limit orders for anything larger than a few hundred shares or on stocks with wide spreads. Market orders on illiquid names can execute far worse than the displayed price, especially on the open/close.
How does the spread affect my returns?
It's a permanent tax on each round trip. If you make 100 round trips per year at 0.1% spread each, that's a 20% annual drag on returns (100 × 2 × 0.1%). Long-term investors barely notice; day traders live and die by it.