Bid-ask spread

how a broker makes money in a stock market .

Lets say you hear a quote of 100-100 1/4, that means that the broker is willing to buy at 100, and is willing to sell at 100.25.   The difference is the spread, and is how the broker makes money. 

Examples:

“Whenever there are wider bid-ask spreads, transactions are generally more profitable,”

The so-called bid-ask spread on about 1,780 investment- grade bonds sold over the past decade averages about 19 basis points, excluding securities with spreads of 100 basis points or more, according to composite pricing data compiled by Bloomberg. That amounts to about $14 in commission per $1,000 bond, compared with about 32 basis points and $24 in commissions in late September. A basis point is 0.01 percentage point.

Bonds are still more profitable than seven years ago when regulators created the Trace bond-pricing service, giving anyone with an Internet connection access to trading details.

The bid-ask spread was about 7 basis points, or $5, for investment-grade bonds before Trace and about 4 basis points, or $3, immediately after, according to a study by Kumar Venkataraman, an associate finance professor at Southern Methodist University’s Cox School of Business in Dallas, published in the Journal of Financial Economics.

How to increase your liquidity (and decrease your WACC).

In order to reduce your cost of capital (the cost of borrowing money, otherwise know as WACC)....you should always try to increase liquidity, which means decreasing the transaction cost of trading your companies stock.  Since you cant directly control item #1 (brokerage fees), this means focusing on items #2 (bid-ask spread) directly, and #3 (market-impact costs) indirectly.

The key to control is the bid-ask spread, which will be higher if the broker is worried that there is an imbalance between informed and uninformed traders.  An informed trader would be someone with knowledge that the broker is unaware of.  These would be the large, sophisticated dealers.  On the other hand, there are the uninformed traders.   If the broker is worried about information thats not known, then he will increase the bid-ask spread, and that will cause an increase in your WACC. 

So, to decrease the WACC, you need to put out lots of information for traders.  By increasing the pool of informed traders, you will decrease the bid-ask spread, and increase the LIQUIDITY of your stock, thereby reducing your cost of capital. 

There are some people that make a career out of being a security analyst (see careers - security analyst).  These people only typically cover large companies.  If you are with a small, uncovered company, then it is in your best interest to release a ton of information yourself, and hope that you get analyst coverage.  This is not to drive up the price of your stock, but instead is to increase the LIQUIDITY of your stock, and drive down your cost of capital. 

Table of Contents:

Definition from Wikipedia

The bid/offer spread (also known as bid/ask spread) for assets is the difference between the price available for an immediate sale (bid) and an immediate purchase (ask). The trader initiating the transaction is said to demand liquidity and the other party (counterparty) to the transaction supplies liquidity. Liquidity demanders place market orders and liquidity suppliers place limit orders. For a round trip (a purchase and sale together) the liquidity demander pays the spread and the liquidity supplier earns the spread. All limit orders outstanding at a given time (i.e., limit orders that have not been executed) are call the Limit Order Book. In some markets such as NASDAQ dealers supply liquidity. But on most exchanges such as the Australian Stock Exchange, there are no designated liquidity suppliers and liquidity is supplied by other traders. On these exchanges, and even on NASDAQ, institutions and individuals can supply liquidity by placing limit orders.

Currency Spread

The Currency rate between the South African rand and the The US Dollar might be 6.50 South African rand to the dollar. A person looking to convert rand into dollars might have to pay 6.55 rand for each dollar, while a person looking to convert dollars to rand might receive only 6.45 rand for each dollar he converts. It is usually written as USD\ZAR 6.45\6.55, or simply 6.45\55. 6.45 is the bid and 6.55 is the ask for 1 USD. USD and ZAR are the International Standards Organization abbreviations for the US and South African currency.

Stock Spread

A person might place an order for 100 shares of Amalgamated Widgets. The broker might attempt to buy 100 shares at $12.50 each, and he would be more than happy to sell those shares at $12.60 apiece, bearing in mind that if he sets his sale price higher, the customer might find another broker with a lower price. As a result, spreads are often only what the market will bear.

On United States stock exchanges, the minimum spread for many shares was 12.5 cents (one-eighth of a dollar) until 2001, when the exchanges converted from fractional to decimal pricing, enabling spreads as small as one cent. The change was mandated by the U.S. Securities and Exchange Commission in order to provide a fairer market for the individual investor.

More

The interest Rate spread refers to the difference between a long-term interest rate and a short-term interest rate (i.e., the slope of the yield curve).

Many financial services companies borrow money at short-term rates (for example, paying low savings-account interest rates to their depositors), and lend at long-term rates (for example, through mortgages). When the interest rate spread is large, this can be a source of significant profit for banks, since they collect interest at high rates but only pay low short-term rates. As the spread shrinks (or even becomes negative), this source of profit disappears.