the impact of bid-ask spreads on the relative investment

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When you view stock prices on a trading screen, you will find that a stock has two quotes - the so-called "bid" price and the so-called "ask" price. For example, suppose you own 100 shares of ABC Corporation, and you want to buy or sell these shares. You obtain a quotation which indicates that the current bid price - the price at which you can sell this stock - is $100 per share, and the current ask price - the price at which you could buy the shares - is $101. These quotes mean that someone is willing to buy at least 100 shares of IBM at $100 and that another person is willing to sell at least 100 shares of the stock at $101. The difference between these bid and ask prices is referred to as the 'bid-ask' spread. In the above example, the spread is one dollar.

If you were to simultaneously buy and sell 100 shares of this stock in the market you would lose the $1.00 spread.

Another way to describe the bid-ask is to say that the "bid price" represents the highest price that somebody will pay for a stock at a particular point in time, whereas the "ask price" is the lowest price at which someone is willing to sell a stock.

Why is there a bid-ask spread? To compensate for the risk that they run, Market Makers seek to buy shares at a lower price and sell at a higher price. The bid-ask spread is, therefore intended to compensate Market Makers for the risk they take in dealing with the stock and keeping the markets liquid.

The size of the bid-ask spread on a particular stock depends on several factors. In general, the more liquid (volume) a stock is the smaller its bid-ask spread will be. Less liquid stocks usually have larger spreads, as do lower priced stocks (in percentage terms). For a fairly liquid stock priced at around $100, a spread of around 75 cents or so is not uncommon.

Note that the bid-ask spread is a "hidden" cost for day traders and other investors. It is a cost that is additional to the normal commissions paid for executing trades. For frequent traders, the bid-ask spread can rapidly erode trading capital. These traders should avoid stocks with inordinately high bid-ask spreads, particularly when using market orders. In particular, it is best to avoid thinly traded stocks or stocks priced under $5.00.

source: http://daytrading.about.com/cs/educationtraining/a/bidask.htm

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