How to Maximise Trades with Bid-Ask Spread & Liquidity

Wealth creation holds the key to a relaxed, stable and comfortable life.

For this purpose, a lot of people choose to invest in assets that are expected to appreciate over long-term.

But for those looking for a larger margin in profits, trading remains the primary device of wealth creation given that you are taking sound trading decisions.

Compared to an investor, a trader is expected to be very knowledgeable about the financial markets. Trading requires a great deal of learning, time and patience as you are on the lookout for the best performing assets nearly all the time.

You are also required to know about the key factors that influence the price movement of an asset or the general conditions of the financial market.

Today, we are going to talk about two key concepts, i.e. bid-ask spread and liquidity, that you need to be well versed in so that you can make the right decisions in the market. 

Scared? Don’t worry, we are here!

At first, both these terms appear to be a little difficult to understand. But don’t let the apparent complexity of the terminology intimidate you.

We are here to make things simple for you.

Let's dive right in.

Define Bid-Ask Spread

A bid-ask spread is the difference between bid price and ask price for an asset:

• Ask Price is the lowest price that a seller is willing to accept for an asset.
• Bid Price is the highest price that a buyer is willing to pay for an asset.

It’s the difference between the quoted price and the selling price of a product in the market.  

Simple to understand, right?

Suppose you have joined a new office, and you are looking for a new pair of shoes for the new place.  

At a shoe store, a seller is offering to sell you a pair of shoes for $50 (ask price).

But you find the price to a little too high and negotiate with the shopkeeper.

Both of you finally settle on $40 for the deal (sell price).

In this case, the bid-ask spread is ($50-$40=) $10. 

Now, you might be wondering why we have taken a scenario where the bid price is lower than the ask price.

But more often than not, this is indeed the case: a bid price is almost always lower than an ask price.

Come on! Are you really going to buy a product against the price tag?

A bid-ask spread is an important factor in the market. It is recommended for traders to keep in mind bid-ask spreads while executing trades.

When purchasing or selling an asset, the bid-ask spread should be carefully considered, especially if it is a low-liquidity transaction. 

 

Define Liquidity

Liquidity is another concept that is quite simple to understand yet crucial to the art of trading.

An asset is considered to be liquid when it can be bought and sold quickly and easily without much difference to its price.

Recommended Read: Understanding Liquidity in Trading

When it is difficult to buy or sell an asset quickly and easily and there is much negotiation over its price, the asset is considered to be illiquid.

• A highly liquid asset can be sold in exchange for cash very easily and efficiently.
• In contrast, an illiquid asset takes a lot of time to get sold, that too at a loss. 

For instance, a flat in Manhattan is nearly always going to be a highly liquid asset. On the other hand, a house in a state like Alaska is going to be very illiquid.

Traders should first consider the liquidity of a stock before purchasing it.

A highly liquid asset lets you enter and exit a trading position easily and quickly. 

This way, you can engage in both short-term and long-term trades for the said stock without a worry.

A market for stocks, derivatives, futures, bonds etc. is highly liquid.

On the other hand, markets for debt instruments and OTC stocks are very illiquid.

Do You Know? Among all the assets, cash is considered to be the most liquid asset as it can be exchanged for other assets quickly and efficiently. 

How is Bid-Ask Spread Related to Liquidity?

An asset’s ask demands liquidity. It is asking for buyers to sell the asset.

Conversely, its bid supplies liquidity. It is looking for sellers to buy the asset.

An asset’s bid-ask spread rises if there are fewer buyers in the market.

Conversely, the spread falls if there are a lot of buyers in the market.

In short, an asset’s liquidity is inversely proportional to its bid-ask spread.

An asset with a narrow bid-ask spread is demanded the most and is highly liquid. An asset with a broad spread is demanded the least and is less liquid.

Some assets, such as large-cap stocks, may have such high supply and demand that the spread is very small.

Other assets, such as micro-cap stocks and certain bonds, may have spreads that account for a significant portion of the asset's price.

What Should BitDelta Traders Know?

We recommend BitDelta traders to learn about both bid-ask spread and liquidity as these metrics are critical to understand the current assessment of an asset and predict its price movement.

While the former lets you understand the dynamic relationship between the trader and the exchange, the latter lets you find whether an asset is in demand or not.

Keep following the BitDelta Academy to learn more about the basics of the financial markets in a detailed yet fun manner.  

A well-read and informed trader makes wise investment decisions even amid any hiccups in the market.