What Is the Bid-Ask Spread and How Do Market Makers Impact It?

When buying or selling a stock, the price you see isn’t always what you get. The bid-ask spread represents the difference between what buyers are willing to pay and what sellers want to receive. This gap exists in nearly every financial market and affects trading costs, especially for frequently traded assets.

Understanding why this spread exists and how it fluctuates helps investors minimize costs. Several factors influence its size, including liquidity, volatility, and order flow. Market makers also play a key role in maintaining efficient markets by facilitating trades.

How Market Makers Provide Liquidity

Market makers keep financial markets running smoothly by continuously posting bid and ask prices, allowing trades to happen without delays. Without them, investors might struggle to find counterparties, leading to slower transactions and unpredictable price movements.

These firms or individuals operate on stock exchanges or electronic platforms, using their own capital to facilitate trades. By maintaining an inventory of shares, they can quickly fulfill buy and sell orders, reducing price swings caused by temporary supply and demand imbalances. This is especially important in markets with lower trading volumes, where the absence of market makers could lead to erratic price fluctuations.

To manage risk, market makers adjust bid and ask prices based on real-time market conditions. If demand for a stock rises, they raise both prices. If selling pressure grows, they lower both. This dynamic pricing helps prevent extreme price discrepancies and keeps trading orderly.

Major Factors That Affect the Spread

The bid-ask spread changes based on market conditions. Three primary factors influence its size: liquidity, volatility, and order flow.

Liquidity

Liquidity measures how easily an asset can be bought or sold without significantly affecting its price. Securities with high trading volume, such as shares of large publicly traded companies, tend to have narrower spreads because many buyers and sellers are active. For example, Apple (AAPL) and Microsoft (MSFT) often have spreads of just a few cents due to their liquidity.

Less frequently traded assets, such as small-cap stocks or certain corporate bonds, typically have wider spreads. Fewer market participants mean it takes longer to match buyers with sellers, and market makers widen the spread to compensate for the risk of holding these securities.

Liquidity also depends on the depth of the order book—the number of buy and sell orders at different price levels. A deep order book keeps spreads tight, while a thin order book can lead to larger spreads, as even small trades can cause noticeable price changes.

Volatility

Volatility measures how much a security’s price fluctuates over time. During volatile periods, bid-ask spreads widen because the risk of sudden price swings increases. Market makers adjust their pricing to account for this uncertainty, ensuring they are not caught holding a position that could quickly lose value.

Economic announcements, earnings reports, or geopolitical events can cause stock prices to move rapidly. A company releasing unexpected financial results may see its stock price jump or drop significantly in a short period, prompting market makers to widen the spread to protect themselves.

Options and other derivatives, which are inherently more volatile than stocks, often have wider spreads. These instruments derive their value from underlying assets and are influenced by factors like time decay and implied volatility, leading market makers to price in additional risk.

Order Flow

Order flow refers to the volume and direction of buy and sell orders. When there is a strong imbalance—such as a surge in buy orders without enough sellers to match them—the spread can widen. Market makers adjust prices to attract counterparties and maintain liquidity.

If a stock experiences a sudden increase in demand, buyers may be willing to pay higher prices, pushing the ask price up. At the same time, sellers may hold out for better offers, causing the bid price to lag behind. This results in a temporarily wider spread until the market stabilizes.

High-frequency trading (HFT) firms, which use algorithms to execute trades in milliseconds, also influence order flow. These firms help narrow spreads by quickly matching buy and sell orders, but they can also contribute to short-term fluctuations. If HFT activity declines, spreads may widen due to reduced liquidity.

Large institutional trades also impact spreads. When a hedge fund or mutual fund places a sizable order, market makers adjust their prices to account for the increased demand or supply. This effect is particularly noticeable in less liquid stocks, where a single large trade can significantly affect the bid-ask spread.

Differences Among Securities

The bid-ask spread varies across financial instruments due to differences in market demand, trading mechanisms, and pricing structures. Stocks, bonds, options, and exchange-traded funds (ETFs) each exhibit distinct spread behaviors.

Equities, particularly those of large publicly traded companies, tend to have relatively tight spreads because they trade on major exchanges with significant investor participation. Blue-chip stocks, like those in the S&P 500, benefit from continuous trading activity, ensuring minimal price discrepancies. In contrast, shares of smaller companies listed on less liquid markets often have wider spreads due to lower trading frequency.

Fixed-income securities, such as corporate and municipal bonds, operate differently. Unlike stocks, bonds do not trade on centralized exchanges but through dealer networks where prices are negotiated. This over-the-counter (OTC) structure leads to wider spreads, particularly for bonds with lower credit ratings or those issued by smaller entities. U.S. Treasury securities, however, tend to have some of the narrowest spreads in the bond market due to their high demand and perceived safety.

Options and derivatives introduce additional complexities. Spreads in these markets are influenced not only by supply and demand but also by factors such as time to expiration and implied volatility. Short-term options with high trading volumes, such as those on major indices like the Nasdaq-100, typically have narrow spreads, while longer-dated contracts or those for less popular stocks often exhibit wider gaps.

ETFs, which track indices or specific asset classes, generally experience spreads that reflect the liquidity of their underlying holdings. Highly liquid ETFs, such as those tracking the S&P 500, usually have tight spreads since their components are frequently traded. However, ETFs focused on niche sectors, emerging markets, or less accessible assets, such as commodities, can have wider spreads due to the challenges in pricing their underlying securities in real time.

How Exchanges Might Influence Spreads

The structure of an exchange affects bid-ask spreads through its trading rules, fee structures, and execution methods. Electronic communication networks (ECNs) allow investors to bypass traditional market makers by matching buy and sell orders directly, often leading to tighter spreads in highly liquid stocks. However, these platforms typically charge access fees, which can offset cost savings from reduced spreads.

Auction-based exchanges, such as the New York Stock Exchange (NYSE), centralize order flow through designated market participants who help maintain price stability. This system can lead to narrower spreads for actively traded securities but may introduce execution delays during volatile periods. In contrast, fully electronic exchanges like Nasdaq rely on multiple competing market participants to provide liquidity, leading to more dynamic spread adjustments.

Rebates and transaction fees also influence spreads. Many exchanges offer incentives to liquidity providers while charging taker fees to those executing market orders. This pricing model encourages traders to post limit orders rather than execute immediately at the prevailing bid or ask, indirectly affecting how spreads fluctuate throughout the trading day.

Regulatory Environment

Government regulations shape bid-ask spreads by ensuring fair trading practices and maintaining market stability. Regulatory bodies such as the U.S. Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) establish rules that govern how securities are traded, aiming to prevent market manipulation and ensure transparency.

One of the most impactful regulations affecting spreads is the Securities Exchange Act of 1934, which established the SEC and set the foundation for modern securities laws. Over time, additional rules have enhanced market efficiency, such as the adoption of decimalization in 2001, which reduced the minimum tick size from one-sixteenth of a dollar ($0.0625) to one cent. This change significantly narrowed spreads for many stocks by allowing more precise pricing increments.

More recently, the SEC’s Regulation National Market System (Reg NMS), introduced in 2005, aimed to improve price competition and ensure investors receive the best available prices. By requiring brokers to route orders to the venue offering the best price, Reg NMS has helped keep spreads tighter, particularly for highly liquid stocks.

Internationally, regulations such as the European Union’s Markets in Financial Instruments Directive II (MiFID II) and financial oversight in Asia influence spreads by enforcing transparency and fair trading practices. These rules increase competition among liquidity providers, indirectly affecting bid-ask spreads across global markets.