How Bid-Ask Spreads Affect Execution Costs and Trading
Summary
The note explains why quoted bid-ask spreads matter for investor transaction costs and why they do not capture every trade price. Trades can occur inside the displayed spread when another venue posts different prices, or when orders meet between the bid and ask at the same venue. It also mentions discretionary orders that accept a less favorable price than their displayed terms suggest.
Investors can cross the spread to trade immediately, or wait for a counterparty and face uncertainty about execution and adverse price movement. Transaction cost analysis therefore often treats spread cost as a fraction that depends on urgency, and investors may incur spread costs again when they exit. The note also describes the continuing role of market makers amid competition among exchanges, electronic venues, and brokers over liquidity, information, rebates, execution speed, and service. These are general explanations, not a formal measurement procedure; the cited within-venue occurrence is a single analysis and should not be treated as a universal rate.
Key ideas
- Trades may execute inside the quoted spread, including across venues with different quotes.
- Crossing the spread buys immediacy, while waiting leaves execution and price uncertain.
- Spread-related costs can recur when a position is closed.
- Market makers remain part of a competitive venue landscape that includes exchanges and electronic networks.
- Quoted spreads do not fully describe trading costs or execution prices.
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# What would be the point of Roll (1984) on measuring the effective bid-ask spread? # What would be the point of Roll (1984) on measuring the effective bid-ask spread? If you look at the original paper of Roll (1984), he explains that part of the transaction costs borne out by investors would be the bid-ask spread and that it was "fraught with measurement problems" and that trading mostly occurred within the quoted spread anyways. So, I would have a trivia questions on this: - Do trades occur within the quoted spread? If so, how do you know? - How exactly is a spread costly to investors? Is it always the same deal on all exchanges for all securities (besides the obvious fact that the spread varies across securities and time)? - A lot of papers from the 1980s reference "market makers." Is it still relevant today? In other words, I'm just looking for bits and pieces of trivia so I can have a better idea of what certain papers are trying to achieve. Thanks! ## Answer by kurtosis (score 5, accepted) https://quant.stackexchange.com/a/57621 Yes, trades do occur within the quoted spread. This occurs often when a trade happens at another venue since that venue has a different quoted spread. It also happens at the same venue as the quoted spread. This can be due to buy and sell orders both arriving and trading between the bid and ask (rare, about 0.3% of the data I analyzed once) or discretionary price orders (which hide that they will accept a worse price). A spread is costly to investors because you either must pay the entire spread for immediacy and guaranteed execution (say, to switch from waiting at the bid to paying the offer price) or because you must wait for someone else to cross the spread -- which leads to uncertainty of your order being filled and the price possibly moving away from your order. Most transaction cost analyses will say you pay some fraction of the spread based on how impatient you are. Note that you need to pay some part of the spread again when you exit that position. Market makers are even more relevant now than in the 1980s. In the late 1990s and early 2000s, the US markets changed policies to allow payments to traders for sending limit orders to a venue (aka "rebates") or marketable orders to a venue (aka "payment for order flow"). This led to intense competition for market share among trading venues with ECNs (electronic communications networks, like order books that automated matching of buys and sells), market makers, and exchanges all competing to offer more pre-trade information (like the order book), rebates or payments for flow, tighter spreads, faster execution, more depth, and better service. Incidentally, there has been progress on estimating bid-ask spreads, even from daily data. You can read more here if you are interested in that.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.