What Determines the Bid-Ask Spread

The bid-ask spread—the difference between the price at which a buyer will purchase and the price at which a seller will sell—is not fixed. It expands and contracts in real time, driven by four fundamental forces: the market maker’s inventory risk, the danger of adverse selection, the volume of orders flowing through the market, and the volatility of the underlying price. A security that trades in heavy volume with low volatility typically has a tight spread; one that trades thinly or with wild price swings typically has a wide one.

Inventory risk and the cost of standing still

A market maker profits by buying at the bid price and selling at the ask price, pocketing the spread. But between those two trades, the dealer holds inventory—shares or bonds or currency sitting on their balance sheet. If the price of that inventory drops before they can sell it, they lose money. This is inventory risk.

To compensate for that risk, market makers widen the spread when they are forced to accumulate more inventory than they want. If a broker-dealer has just bought 50,000 shares of a stock at the bid and wants to unload them quickly, they will lower the ask price—widening the spread below fair value—to attract a buyer. Conversely, if they are short inventory and desperate to buy, they will raise the bid price—again, widening the spread—to pull in sellers. The wider the spread, the better their margin for error if price moves against them before they hedge.

On heavily traded securities where inventory turns over in seconds, inventory risk is minimal and spreads stay tight. On thinly traded securities, where a dealer might hold inventory for hours or days, the spread widens to compensate for the risk of an adverse price move.

Adverse selection: the information hazard

Adverse selection is the risk that the person on the other side of your trade knows something you do not. Imagine a market maker posting a bid of $50 and an ask of $50.10 for a stock. If someone immediately sells to the bid (at $50), the dealer wonders: why did they sell right now? Did they hear bad news before it was public? If the stock drops to $49 an hour later, the dealer just bought at the top from an informed seller. Conversely, if a buyer immediately hits the ask (at $50.10), the dealer wonders if that buyer knows something bullish.

Market makers cannot know whether they are trading with an insider or a retiree liquidating a position. But they can infer the probability based on the speed and pattern of orders. In thinly traded or illiquid markets, the risk of adverse selection rises—anyone willing to trade in a thin market is more likely to be informed. To protect against that risk, dealers widen the spread.

This explains why the spread on a penny stock is so much wider than on Apple: in a penny stock, anyone stepping up to trade might be a nimble trader with special knowledge. Apple is so heavily traded that any single buyer or seller is just a drop in the ocean, making it harder for them to have meaningful private information.

Order flow and liquidity concentration

A tight spread requires consistent, two-sided order flow. When many buyers and sellers are queuing to trade, a market maker can easily match orders and turn over inventory rapidly. The more liquid the market, the less time the dealer spends holding risk, and the smaller the spread can be.

During normal market hours on highly liquid securities like the S&P 500 index futures or major forex pairs (such as EUR/USD), spreads compress to a few cents or basis points because order flow is enormous and continuous. During low-volume times—such as pre-market trading or overnight sessions—the same securities widen considerably. The market maker has to wait longer to find a counterparty, so they widen the spread to compensate.

Similarly, a stock that suddenly becomes illiquid (because a major holder is not trading, or retail interest dries up) will see its spread widen, even if the fundamental value of the company has not changed. The market maker is simply responding to a lower expectation of order flow.

Volatility: the wildcard factor

When a security’s price swings wildly, uncertainty about fair value rises. If a stock can move 3% in a single minute, the probability that a trade at today’s price will be disadvantageous to the dealer on the other side rises sharply. To protect themselves, dealers widen the spread.

This is easiest to see during earnings season or economic data releases. In the minutes before a company reports earnings, implied volatility and spreads both widen. Dealers know price will likely jump; they want a bigger margin to protect against being caught on the wrong side. Immediately after the news, if the new price settles and volatility falls, spreads snap tight again.

The relationship is so consistent that volatility is one of the strongest real-time drivers of spread width. A stock with an annualized volatility of 15% will have a tighter spread than one with an annualized volatility of 60%, all else equal.

How the four factors interact: real-world examples

Consider three securities:

Apple (AAPL): High-volume blue chip, low volatility, deep order book. Spreads are often just 1 cent. Inventory risk is trivial because turnover is instant. Adverse selection risk is low because the market is so deep. Order flow is continuous. Volatility is moderate.

Emerging-market currency pair (e.g., USD/MXN): Decent volume, moderate volatility, but less deep than major currencies. Spreads might be 0.5 to 1.0 pip wider than EUR/USD. More inventory risk, slightly higher adverse selection risk.

A micro-cap stock or illiquid corporate bond: Very low order flow, high adverse selection risk (anyone willing to trade might be fleeing bad news), high inventory risk (dealer might hold for hours), and often elevated volatility. Spreads can be 1–2% of the bid price or wider.

The spread as a cost and a signal

From a trader’s perspective, the spread is a cost: every round-trip transaction costs you the spread. From a market microstructure perspective, the spread is a signal: a wide spread tells you the market is uncertain, illiquid, or risky. Watching the spread can tell you when a security is under stress (spreads widen) or when confidence is returning (spreads tighten).

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