Hello everyone. I want to thank @awesononso for this nice lecture about the bid-ask spread and this is how am going to answer the home work questions as below.
Properly Explain the Bid-Ask spread.
First and foremost am going to explain what the Bid-ask spread means .
So this is the difference between the highest price that a buyer is willing to pay for an asset and the lowest price that the seller is willing to accept.
Also the bid-ask spread can be considered as a measure of supply and demand for a particular asset or commodity.
Bid price refers to the price of an asset at which a buyer is willing to buy at a very lowest prices and it represents demand of an asset.
Ask price refers to the price of an asset at which the owner is willing to sell and so it is always at a highest level compared to the bid price. This represents the supply of an asset.
Let’s check the graph below where the green color represents a bid price and red color represents an ask price and so in between where you see a gap is the liquidity level in the market as discussed above.
Why is the bid-ask spread important in the market.
As well discussed the meaning of Bid-ask spread let us look at why it is important in the market.
•Bid-Ask spread is a guide on the type of order to Ben placed. For instance if the bid ask spread are narrow , you can get the best price with the market order itself. However if the spreads are wider , then a limit order will be a better choice.
•Bid-ask spread also is a measure of trading stock. That isn’t executing a buy or order in the market is to get the stock as close to the best price as possible. Higher the bid ask spread , the higher the risk in trading the stock which imposes an indirect cost on trading.
•Also the Bid-ask spread is an important barometer of liquidity of an asset. Normally more liquid the stock, the more actively it changes hands and finer the pricing. High liquid stocks that are part of of nifty and sensed have very low bid-ask spread as they are sufficiently liquid.
If crypto X has a bid price of $5 and an ask price of $5.20,
a)calculate the bid-ask spread.
b)calculate the bid-ask spread in percentage.
Solution
a)from the formula
Spread = Ask price - bid price
= $5.20 - $5
=$0.20 which is the bid-ask spread
b)percentage wise,
Percentage spread = (spread/ask price) * 100
= (0.20/5.20)*100
= 3.85%
If crypto Y has a bid price of $8.40 and an ask price of $8.80 ,
a)calculate the bid-ask spread.
b)calculate the bid-ask spread in percentage.
Solution
a) from the formula above
Spread = $8.80 - $8.40
= $ 0.40
b) percentage
Spread = (0.40/8.80)*100
= 4.545%
In one statement, which of the asset should above has the higher liquidity and why.
As me I say that crypto X has the highest liquidity compared to crypto Y because of the smallest spread of $0.20 which shows the high liquid state in the market.
Explain slippage.
Slippage refers to the situation in which a market participant receives a different trade execution price than intended. This occurs when the bid-ask spread changes between the time a market order is requested and the time an exchange executes the order.
Explain positive slippage and negative slippage with price illustration for each.
Positive slippage is when the bid price in short trade increases and the ask price in long trade decreases that is implying a lesser gap between the price buyer is willing to pay more than the price seller is willing to accept.
Price illustration
Let’s take an example if a person has a bid price of $3.20 and the ask price in the market is decreasing at $3.00 then that is a positive slippage of $0.20 since it is a lesser gap left.
Negative slippage is when the ask price increases in the long trade and bid price decreases in the short trade implying a wider gap between the price the seller isn’t willing to accept and the price the buyer is willing to pay.
Price illustration
If someone has a bid price of $5.20 and yet the ask price isn’t increasing at $6.20 then it will imply a negatinve slippage because the seller will incur a loss of $1 which I spent really a wider gap left.
Thank you professor for this wonderful lecture.