Bid-Ask Spreads and Liquidity in US Equities

Every trade in US equities involves two prices: what buyers pay and sellers accept. The gap between these prices—the bid-ask spread—is a foundational market mechanic that directly impacts investment returns. For new investors, grasping how spreads and liquidity function clarifies why trades execute at specific prices and how to minimize avoidable costs.

When you buy or sell a stock, the bid price reflects the highest amount a buyer is willing to pay, while the ask price is the lowest a seller will accept. The difference between these prices, often just fractions of a cent for liquid stocks, represents the cost of immediacy in trading. Liquidity—the ease of buying/selling without moving the market—determines how wide or narrow these spreads are. This article explains how these mechanics work and why they matter for your portfolio.

Definition and Key Concepts

The bid price is the maximum price buyers are willing to pay for a stock at a given moment. The ask price is the minimum price sellers will accept. The bid-ask spread is the difference between the two (e.g., a stock trading at $150.00 bid and $150.01 ask has a $0.01 spread). Liquidity refers to how easily an asset can be traded without affecting its price. High liquidity typically means narrow spreads, while low liquidity results in wider spreads.

Key metrics include spread percentage (spread divided by the mid-price) and trade size. For example, a $0.01 spread on a $150 stock represents a 0.0067% cost. Liquidity is also measured by daily trading volume (e.g., Apple trades ~50 million shares daily) and order book depth.

How It Works in Practice

In practice, spreads emerge from supply and demand dynamics. Market makers—firms that provide liquidity—profit from the spread by holding inventory of stocks. For highly liquid stocks like Microsoft, spreads are often 1–2 cents wide. For less liquid stocks, spreads can widen to $0.10 or more.

Consider a stock with a bid of $25.40 and ask of $25.45. If you place a market buy order, you’ll pay $25.45 per share. If you immediately sell, you might only receive $25.40, absorbing the $0.05 spread as a transaction cost. Liquidity also affects slippage: large orders may execute at worse prices if there aren’t enough buyers or sellers to fill them.

Worked Example: The Cost of Spreads

Imagine purchasing 100 shares of XYZ Corp at a $25.45 ask. Your total cost is $2,545. If you sell immediately at the $25.40 bid, you receive $2,540—a $5 loss, or 0.196% of your initial investment. This loss isn’t due to market movement but simply the cost of trading. For a $10,000 portfolio, repeated trades with 0.2% spread costs could erode ~$200 annually in otherwise unproductive expenses.

Compare this to a liquid stock like Tesla (TSLN), which might have a $0.05 bid and $0.06 ask. A 100-share round trip would cost $1 (0.01% of a $1,000 trade). Over time, trading in liquid stocks reduces these frictional costs.

Risks, Limitations, and Tradeoffs

While spreads are unavoidable, they can become problematic in certain scenarios. Illiquid stocks (e.g., small-cap or low-volume names) often have wide spreads that amplify transaction costs. During market stress, liquidity can dry up rapidly, causing spreads to widen dramatically (e.g., penny stocks may jump from $0.10 spreads to $1.00 during panic selling).

Another tradeoff: narrow spreads require active market makers, which may not exist for less popular stocks. Additionally, high-frequency traders can exploit liquidity imbalances, sometimes front-running orders or creating artificial spreads. Investors must also weigh the time value of liquidity—trading after hours often results in wider spreads due to lower participation.

Checklist and Next Steps

• Check bid-ask spreads before executing trades, especially for low-volume stocks.
• Use limit orders to avoid unexpected execution prices.
• Prioritize stocks with daily trading volumes above 1 million shares.
• Monitor how spreads change during market open/close and news events.
• Calculate annualized trading costs to assess their impact on returns.

Review your brokerage platform’s order book features, track spread changes for your watchlist stocks, and consider liquidity as a factor in your investment strategy. Understanding these mechanics empowers you to make cost-conscious decisions and avoid hidden drag on portfolio performance.