May

17

The bid/ask spread is another one of those hurdles that speculators must jump over in the quest for profitable trades. The spread is the instantaneous inside market, reflecting current market conditions, but it also is a product of unbridled free market forces. The bid/ask spread is a profit engine, for those in the right place at the right time, make no doubt about that. Many of the great fortunes on Wall Street were the result of always being able to buy at the bid, and sell at the offer.

In earlier times, people would pay for the privilege of an exchange membership in order to capture this spread. It must have been a worthwhile investment, as exchange membership prices have gone up on average for the last century. Now, in these more democratic, electronic times, it is harder to collect the spread on an all day, everyday basis. Much more confusion at the bid/ask point of the market reigns in this digital age. The mistress of deception likes to have her way with this spread. In today's supposedly open electronic age, where tyros see transparency in the markets, the same ages-old bluffing, misdirection, feints, probes, and stabs rule the inside market, as always. The same deceptive games played in the open outcry market have seamlessly morphed into the electronic markets, but with much more ruthless efficiency. Big players can see the open book, get the little ducks all lined up in a row, then slaughter them mercilessly. The inside market, the bid/ask spread, is tough to trade from anywhere on the outside, especially if you're a small player. Limit orders attempt to avoid the bid/ask spread, but one is really not avoiding the spread with a limit order when you think about it. Market orders give the other side of the trade an instantaneous profit, or return on their investment. No matter what you do, you're going to bump up against the spread, as it's unavoidable.

The bid/ask spread can represent the minimum amount of risk a player is going to assume, or it can cause a maximum amount of pain, it's your choice. Liquidity seems to rule the day in the bid/ask spread, with the more liquid instruments having narrow spreads, and some illiquid instruments (like pink sheet stocks) having up to a 10% spread. The spread can still change in liquid instruments, depending on the free market forces, fear, greed, deception, or any other emotion in nature's handbasket.

Emotions come into play when you are trying to get a trade down and don't get filled because the bid/ask spread won't allow it. Emotions can cause you to chase a market while the bid/ask spread seductively dangles a carrot in front of you. Emotions can cause you to avoid a good trade because of a perceived increase in risk when the spread is wider and you don't want to pay the cost, or assume any extra risk. I like to keep an eye on the spread, as I find that it gives many, many valuable market indicators, especially in thin markets and after-hours. However, like commission, vig, slippage, and mistakes, I accept the bid/ask spread as part of the cost of doing business.

Legacy Daily comments:

Some of the volatility seems to be created to soak up more money from the participants in the form of the spread but even with this money printing-press the houses got slammed in the past year. With their collective voice, maybe they would say that is their cost of doing business but I am yet to fully comprehend the societal impact of a bid/ask spread between a 1% deposit and a 5% loan. 

Phil McDonnell writes:

The bid/ask spread, volatility and liquidity are very much related concepts. When the spread is wide there is usually greater volatility. When volatility is greater the spreads widen. It is difficult to say which causes the other, rather it is safer to reason that they are manifestations of the same underlying phenomenon. In both cases that phenomenon may be liquidity or lack thereof.

The bid/ask spread and volatility are directly observable. But underlying liquidity is a hidden variable which cannot be directly observed. The St. Louis Fed has done some limited research looking for the underlying cause of volatility. In that work they found that consumer liquidity was highly correlated with market volatility. That offers a strong hint that liquidity, spreads and volatility may all be manifestations of the same thing.

Dr. McDonnell is the author of Optimal Portfolio Modeling, Wiley, 2008

George Parkanyi responds:

The spread is a market price in its own right –- the price of liquidity, and also of laying off risk. If you want to establish a full position immediately, or liquidate one, you pay the price for that convenience. If your small orders can piggyback the action of the big lines in a liquid market, then you don’t have to pay very much at all. If you’re the only guy walking up to the table, it can be pretty-much take it or leave it when things are thin. Market makers maintain a position in the security indefinitely. They can wait you out. Your interest is typically transitory, and you often want to get in quickly to act on an idea, or get out and move on to something else. You don’t have as intimate a relationship with that market. So the bid-ask is in effect a service, for which you pay a price.

I’ve stopped trading certain ETFs because they are too thin. The spread on the thinner ones was sometimes 10%, and even when I was getting a signal I couldn't always execute. This was disruptive, so now I’ve spent some additional effort weeding out thin markets where the spread is too costly, or makes me miss signals that would otherwise be profitable if I were trading a similar, more liquid security.

I’ve thought about and played with spreads a lot, and believe that with adequate capital, you can effectively simulate being a market-maker yourself by maintaining a “virtual” bid-offer. You simply put in limit orders to buy and sell at certain increments. The profitability of your “market-making” depends on how wide you make your “spread”, and how volatile the security. Too wide the spread and you might not get enough action to warrant the risk, too narrow and you may pick up a whole lot of inventory going the wrong way that you don’t want. Looking at the profitability of the specialist system, I believe you can make good money with a strategy like this in a market in which you have a reasonable grasp of the dynamics, although you won’t have the visibility of other limit orders — you’ll have to do it statistically.


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