Lesson 4 of 9
Costing a round trip
The bid-ask spread is a fee nobody itemises. Compute it as a percentage of the position, watch it double on a round trip, and see what size does to it.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
Who writes thisEditorial processLinkedIn (opens in a new tab)X (opens in a new tab)
In one minute
- The spread is a real cost, charged once on the way in and once on the way out, and it appears on no statement.
- Half the spread is the honest cost of a single trade, because a fair value sits between the two quoted prices.
- Spread cost is a percentage of the position and does not shrink with size, while a large order in a thin book adds a second cost on top.
Two prices exist at once: the price you can sell at and the higher price you can buy at. The gap between them is the spread, and crossing it is what a trade costs before any commission.
Nobody sends you an invoice for it. It is embedded in the price, which is exactly why it is worth computing once by hand.
The same round trip, three books
- Penny spread on a $40 share0.05percent of position
- Ten-cent spread on a $40 share0.50percent of position
- Forty-cent spread on a $40 share2.00percent of position
The computation, in five steps
Costing a round trip by hand
- Write down the bid and the ask. Say the bid is $39.90 and the ask is $40.10.
- The spread is the ask minus the bid: $0.20.
- The midpoint is the two added and halved: $40.00. Treat that as the fair price for this purpose.
- Buying at the ask costs $0.10 above the midpoint. Selling at the bid costs $0.10 below it. Each single trade costs half the spread.
- A round trip pays both halves, so the cost is the whole spread: $0.20 a share, which on a $40 share is 0.5 percent of the position.
The rule that falls out of step five is worth memorising, because it is the only arithmetic in this lesson. The round-trip spread cost, as a percentage, is the spread divided by the midpoint.
Why a percentage and not a dollar amount
Twenty cents sounds small and $2,000 sounds large, and they can be the same thing. The only way to compare a spread across two companies is to divide it by the price.
Round-trip spread cost equals Ask − bid divided by Midpoint price.
Example($40.10 − $39.90) ÷ $40.00 = 0.50%
A four-cent spread on a $400 share is 0.01 percent. A four-cent spread on a $2 share is 2 percent. The dollar amount is identical and the cost differs by a factor of two hundred.
Size makes it worse, not better
A commission is often fixed, so buying more shares spreads it thinner. The spread does not work that way. It is charged per share, so the dollar cost rises with size while the percentage stays the same.
And beyond the size quoted at the best price, a second cost appears: the order walks up the book and pays worse prices for the rest. That is why a large order in a thin company can cost several times the quoted spread.
What a long-term investor should take from this
Two things, and neither of them is a trading technique.
First, turnover is expensive in a way that is invisible. A strategy that looks attractive on paper and requires frequent trading in thinly traded companies is paying this cost every time, and the paper version never charges it.
Second, liquidity is a property of the holding, not of the company. A business can be excellent and its shares can still be costly to enter and leave. Those are separate questions and the second one is answered by daily volume and the spread, not by the accounts.
Check yourself
The bid is $39.90 and the ask is $40.10. What does one purchase cost against the midpoint?
- The full $0.20 spread
- Half the spread, $0.10 a share
- Nothing, since the midpoint is not a real price
Show the answer
Answer: B.
Each single trade crosses half the spread. The full spread is paid only by a round trip, which crosses it once in each direction.A four-cent spread appears on a $400 share and on a $2 share. What is true?
- Both cost the same, because the spread is the same
- The $2 share costs two hundred times more as a percentage of the position
- The $400 share costs more, because more money is at stake
Show the answer
Answer: B.
Four cents on $400 is 0.01 percent. Four cents on $2 is 2 percent. Comparing spreads in cents compares nothing.Why does buying more shares not dilute the spread cost, the way it dilutes a fixed commission?
- Because brokers charge extra for large orders
- The spread is charged per share, so the cost rises in proportion and the percentage stays flat
- Because large orders always get price improvement
Show the answer
Answer: B.
A fixed fee divided by more shares gets smaller per share. A per-share cost does not, and past the quoted size the order also walks the book and pays more.Sources
- Rule 605 of Regulation NMS, on published execution quality statistics including effective spread and price improvement by order size.
- SEC investor education material on bid-ask spreads and the costs embedded in a quoted price.
What this leaves out
- All prices, spreads and yields here are invented round numbers, chosen so the arithmetic can be checked by hand. No real security is described.
- Real fills often land inside the quoted spread, so the quoted figure is an upper bound on a small order's cost rather than the exact charge.
- Spreads widen around news, at the open and at the close, and the quote read at one moment does not describe the next.
- Nothing here is advice about any security or any trading frequency.