How Spreads Work

What is a Spread?

The bid-ask spread is the difference between the highest price a buyer is willing to pay (the bid) and the lowest price a seller is willing to accept (the ask). It is the most fundamental concept in market microstructure and the primary lens through which liquidity is measured.[1]

When you see a stock quoted at $100.00 / $100.05, the spread is 5 cents. That tiny gap represents the cost of immediacy — if you want to buy right now rather than wait for someone to match your limit order, you pay the ask. If you want to sell right now, you hit the bid. The market maker, standing in the middle, collects the difference.

Why Spreads Exist

Spreads exist as compensation for three distinct costs that market makers bear:

• Inventory cost: holding a position exposes the market maker to price risk. The longer they hold, the greater the chance the price moves against them.
• Adverse selection cost: some counterparties are informed traders who possess superior information. Trading with them systematically leads to losses for the market maker.[2]
• Order processing cost: the operational overhead of maintaining quotes, managing systems, and executing trades.

The relative contribution of each component has been the subject of decades of academic research, with adverse selection generally considered the most significant driver in equity markets.[3]

Tight vs Wide Spreads

Several factors determine how tight or wide a spread will be:

• Volatility: higher volatility means greater inventory risk, so spreads widen to compensate.
• Trading volume: high-volume assets attract more market makers, and competition compresses spreads.
• Competition: more market makers quoting the same instrument drives spreads toward their theoretical minimum.
• Information asymmetry: assets with more informed trading (e.g., around earnings announcements) see wider spreads.

In highly liquid instruments like S&P 500 ETFs or major forex pairs, spreads can be as tight as one hundredth of a percent. In illiquid small-cap stocks or exotic crypto tokens, spreads can be several percent wide.

Spread as Income

For a market maker, the spread is the gross margin on each round trip. Buy at the bid, sell at the ask, pocket the difference. But the catch is that round trips rarely happen cleanly. You might buy 100 shares at $100.00 and then the price drops to $99.50 before you can sell. Your “spread income” just turned into a loss.

The art of market making is in managing this asymmetry: capturing enough spread on your winning round trips to more than offset the losses from inventory movements and adverse selection. This requires constant adjustment of quote prices, position sizes, and risk parameters.

Realized vs Quoted Spread

The quoted spread is what you see on the order book at any given moment. The realized spread is what the market maker actually captures after accounting for price movements. Academic research consistently shows that realized spreads are significantly lower than quoted spreads, because prices tend to move against the market maker after a trade — a hallmark of adverse selection.[2]

The Economics

Consider a simple example. A market maker quotes a bid at $99 and an ask at $101. The quoted spread is $2. If they buy at $99 and the “true” value is $100, they made $1 on the buy. If they later sell at $101 and the true value is still $100, they make another $1 on the sell. Total profit: $2 on the round trip. But if the true value shifts to $98 after they bought at $99, they’re already losing money before they can sell. Managing this dynamic is the entire challenge — and the entire opportunity — of market making.