What Types of Stocks Have a Large Difference Between Bid and Ask Prices?

The bid-ask spread is the difference between the highest offered purchase price and the lowest offered sales price for a security. Brokers often quote the spread as a percentage, calculated by dividing the bid/ask difference by either the midpoint or ask. In the case of equities, these prices represent the demand and supply for shares in the stock market. The primary determinant of bid-ask spread size is trading volume. Thinly traded stocks tend to have higher spreads. Market volatility is another important determinant of spread size. Spreads usually widen in times of high volatility.

Key Takeaways

• The bid-ask spread is the difference between the highest offered purchase price and the lowest offered sales price.
• Highly liquid securities typically have narrow spreads, while thinly traded securities usually have wider spreads.
• Bid-ask spreads usually widen in highly volatile environments.
• Traders can manage stocks with wide spreads by using limit orders, price discovery and all-or-none orders.

Understanding Bids, Asks, and Bid-Ask Spread

In financial markets, a bid is the highest price a buyer is willing to pay for an asset, such as a stock, bond, or commodity, at a given moment. It represents the demand side of the market, showing the level of interest from potential buyers. For example, if a trader wants to purchase a share of a stock and submits a bid of $100, this amount reflects their maximum willingness to pay, or the bid.

An ask, on the other hand, is the lowest price a seller is willing to accept for the same asset. It reflects the supply side of the market, showcasing the willingness of sellers to part with the asset. Continuing the example, if a seller lists their shares with an ask price of $102, this indicates they are only willing to sell at that price or higher.

The bid-ask spread is the difference between the bid price and the ask price. In the example above, the spread is $2 ($102 ask – $100 bid). This spread represents transaction costs, liquidity, and market efficiency. A narrow spread indicates high liquidity, as buyers and sellers are closer in agreement. A wider spread suggests lower liquidity and higher costs for traders.

With that overview behind us, let’s look at the types of stocks that tend to have higher differences between bid prices and ask prices.

Note

Some investors may prefer pursuing the arbitrage opportunity of a large bid-ask spread; others may avoid it for the risk of loss.

Types of Stocks with Large Bid-Ask Spreads

First things first: each stock might be uniquely positioned with a large or small spread, regardless of whether it fits into any of these categories below. However, very generally speaking, the following types of stocks have larger bid-ask spreads:

Small Cap Stocks

Small-cap stocks, or stocks from companies with a relatively low market capitalization often experience larger bid-ask spreads. These stocks tend to be less liquid because they are less widely followed by analysts and investors. Fewer shares are traded daily, making it harder for buyers and sellers to come to an agreement on price. This may also include penny stocks, or stocks trading for less than $5.

Low Volume Stocks

Stocks with low trading volumes often exhibit wider bid-ask spreads due to limited market activity. When a stock has few trades occurring throughout the day, market makers and liquidity providers have to adjust the prices between the bid and ask to reflect the risk of holding the stock. Without enough buyer and seller interest, it becomes more difficult for transactions to occur at a fair price, which results in a wider spread.

Emerging Markets

Emerging market stocks are also prone to larger bid-ask spreads. These markets often have lower liquidity compared to developed economies, and stocks may not be as actively traded. Economic, political, and currency risks associated with emerging markets can also deter investors, further reducing trading activity. As a result, the lack of market depth forces the bid-ask spread to widen, which can add costs and risks for traders.

Over-the-Counter Stocks

OTC stocks, which are traded via a dealer network instead of centralized exchanges, tend to have significantly wider bid-ask spreads. These stocks are often from smaller companies or those with questionable financials, and they lack the oversight and regulation of stocks traded on major exchanges like the NYSE or NASDAQ. The lack of centralized liquidity, along with increased risk for investors, leads to a situation where dealers raise the spread to compensate for the uncertainty and lack of buyer-seller matching.

Stocks with High Volatility

Stocks that experience significant price fluctuations tend to have larger bid-ask spreads. High volatility creates uncertainty in pricing, making market makers reluctant to offer a tight spread. As prices fluctuate rapidly, market participants want to protect themselves from the risk of losing money on a trade since the price may be bouncing around.

How to Trade Stocks with Wide Bid/Ask Spreads

Use Limit Orders: Instead of blindly entering a market order for immediate execution, place a limit order to avoid paying excessive spreads. Let’s assume David wants to purchase a small-cap stock and the best bid is 30 cents, while the best offer is 50 cents. David could enter a buy limit order at 31 cents, which sits at the top of the bid giving him priority over all other buyers. Alternatively, if David was a seller, he could place a sell limit order at the top of the offer at 49 cents.

Price Discovery: Often, stocks that have wide spreads trade infrequently. Even if a trader uses limit orders, they can sit on the bid or ask for days without getting executed. Test out the market by incrementally increasing the buy limit price and decreasing the sell limit price. For example, If Emily currently sits at the top of the bid at $1.00 and the best offer is $1.25, she could perform price discovery by raising her limit order by 5 cents each day for a week to test the willingness of a seller to come down to her bid price. 

Avoid All-or-None Orders: These orders specify that the total number of shares bought or sold gets executed, or none of them do. In wide bid/ask markets, liquidity is often thin, meaning a trader could miss out on acquiring shares if only small parcels of stock get traded. For instance, if Tom has placed an all-or-none buy limit order for 5,000 shares at $1.00 and a seller enters the market with 4,999 shares to offload at the bid price, the trade wouldn’t execute due to a shortage of units to fill Tom’s order in its entirety i.e., one share short.

What Types of Stocks Have a Large Difference Between Bid and Ask Prices?

Stocks with higher volatility, less liquidity, less trading activity, or small market caps may be more likely to have larger bid-ask spreads.

What Is the Difference Between Bid and Ask Prices?

The bid price is the highest price a buyer is willing to pay for an asset, while the ask price is the lowest price a seller is willing to accept. The bid-ask spread is the difference between these two prices.

Why Do Stocks Have Bid-Ask Spreads?

Bid-ask spreads exist because of the need for market makers to facilitate transactions between buyers and sellers. Market makers provide liquidity by standing ready to buy and sell assets. The spread compensates them for the risk of holding the asset and for the costs associated with finding a counterparty.

What Factors Affect Bid-Ask Spreads?

Bid-ask spreads are influenced by several factors, including the liquidity of the asset, market volatility, trading volume, and the overall supply and demand for the asset. Stocks with low trading volumes, such as small-cap or penny stocks, tend to have larger spreads due to less frequent price matching between buyers and sellers as well.

The Bottom Line

Factors such as liquidity, volatility, and market conditions affect the size of the spread, with illiquid or volatile assets often having wider spreads. Larger spreads can benefit market makers by compensating them for risks, but they also increase transaction costs for traders, particularly in less liquid markets.