The bid-ask spread is the difference between the lowest available ask (the price at which the market will sell to you) and the highest available bid (the price at which the market will buy from you). It represents the minimum round-trip cost of an immediate market-order execution.
The spread compensates market makers for two costs: inventory risk (holding positions they did not seek) and adverse selection (the risk of trading against an informed counterparty who knows something the market maker does not). In liquid markets it is very narrow — fractions of a basis point for large-cap equities. In illiquid markets it can be several percent of the asset's price.
Components of the spread
- Inventory cost — compensation for the market maker's risk of holding an unwanted position
- Order processing cost — administrative overhead of matching trades
- Adverse selection component — the cost of potentially trading against informed flow (related to Kyle's λ)
The effective spread — what a market-order trader actually pays after execution — can be estimated from the Roll (1984) estimator using only price data.