Bid/Ask Spreads

When it comes to the cost of trading most investors only think of the direct costs, also known as the commissions. However there is another more important indirect cost know as the bid/ask spread premium. This is especially important when investing in illiquid stocks or products. On an illiquid company or product, the bid/ask spread can cost as much as 10% of the purchase price. However usually the Bid/Ask spread on most stocks and ETF’s are never greater than 0.10%. Large spreads can also appear in liquid stocks and ETF’s, when the underling security has a high beta (a.k.a volatility).

Definitions:
Bid Price : The price a buyer is willing to pay for a security.
Ask Price :The price a seller is willing to accept for a security, also known as the offer price.

When buying and selling a stock, CEF or ETF one solution is to put a limit order on the security to protect yourself if the spread is wide. Last Friday for example, on the TSX, I’ve noticed that an individual bought an ETF at a 58% premium since there was no liquidity, so the closest ask was at such at such large premium. If this individual took just 10 seconds to put the limit order he would have saved lots of money.

While one usually will not face large spreads, being aware of this is critical if ever you encounter a situation where you want to buy or sell an illiquid product.