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I know the obvious costs of trading stocks, like commissions, fees and taxes. But I also hear people saying the bid ask spread is part of the transaction cost. Why is this the case? One of the explanations is that if you buy at the ask price and want to sell it right away, you can only sell at the bid price. This is a loss of shares*spread. But if I don't do that, then there doesn't seem to be any cost for me. Or is bid ask spread some kind of opportunity cost?

UPDATE I just looked up the definition of transaction cost, and it is given as follows:

"In economic terms, Robert Kissell (2006) describes them as costs paid by buyers, but not received by the sellers."

This is rather intuitive.

  • Correct. For long term buy and hold, bid-ask spread is not so much a concern as the stock actually moving against you. – Victor123 Mar 16 '15 at 21:09
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Your assets are marked to market.

If you buy at X, and the market is bidding at 99.9% * X then you've already lost 0.1%.

This is a market value oriented way of looking at costs.

You could always value your assets with mark to model, and maybe you do, but no one else will. Just because you think the stock is worth 2*X doesn't mean the rest of the world agrees, evidenced by the bid. You surely won't get any margin loans based upon mark to model. Your bankers won't be convinced of the valuation of your assets based upon mark to model.

By strictly a market value oriented way of valuing assets, there is a bid/ask cost.

more clarification

Relative to littleadv, this is actually a good exposition between the differences between cash and accrual accounting.

littleadv is focusing completely on the cash cost of the asset at the time of transaction and saying that there is no bid/ask cost. Through the lens of cash accounting, that is 100% correct.

However, if one uses accrual accounting marking assets to market (as we all do with marketable assets like stocks, bonds, options, etc), there may be a bid/ask cost. At the time of transaction, the bids used to trade (one's own) are exhausted. According to exchange rules that are now practically uniform: the highest bid is given priority, and if two bids are bidding the exact same highest price then the oldest bid is given priority; therefore the oldest highest bid has been exhausted and removed at trade.

At the time of transaction, the value of the asset cannot be one's own bid but the highest oldest bid leftover. If that highest oldest bid is lower than the price paid (even with liquid stocks this is usually the case) then one has accrued a bid/ask cost.

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    So you're considering it an "opportunity cost" then? How is it not reflected in the transaction loss when you actually do the sell? – littleadv Apr 26 '13 at 1:21
  • Whether a spread is due to an illiquid market, volatility or market makers it is still a spread. – user9722 Apr 26 '13 at 1:26
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    @JoeCoderGuy - exactly. – user9722 Apr 26 '13 at 2:53
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    It is not a true cost because you didn't pay it. You cannot call something you didn't pay a cost. It may represent a drop in the snap-shot value, but it is not a cost. – littleadv Apr 26 '13 at 3:28
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This is a misconception.

One of the explanations is that if you buy at the ask price and want to sell it right away, you can only sell at the bid price.

This is incorrect. There are no two separate bid and ask prices. The price you buy (your "bid") is the same price someone else sells (their "sell"). The same goes when you sell - the price you sell at is the price someone else buys.

There's no spread with stocks. Emphasized it on purpose, because many people (especially those who gamble on stock exchange without knowing what they're doing) don't understand how the stock market works. On the stock exchange, the transaction price is the match between the bid price and the ask price. Thus, on any given transaction, bid always equals ask. There's no spread.

There is spread with commodities (if you buy it directly, especially), contracts, mutual funds and other kinds of brokered transactions that go through a third party. The difference (spread) is that third party's fee for assuming part of the risk in the transaction, and is indeed added to your cost (indirectly, in the way you described). These transactions don't go directly between a seller and a buyer.

For example, there's no buyer when you redeem some of your mutual fund - the fund pays you money. So the fund assumes certain risk, which is why there's a spread in the prices to invest and to redeem. Similarly with commodities: when you buy a gold bar - you buy it from a dealer, who needs to keep a stock. Thus, the dealer will not buy from you at the same price: there's a premium on sale and a discount on buy, which is a spread, to compensate the dealer for the risk of keeping a stock.

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    So if I have stock XYZ with a bid of $9.50 and ask of $10.00 what is this called? – user9722 Apr 25 '13 at 22:31
  • You also mention in your answer that it is an indirect cost, which means it is not a transaction cost, as a transaction cost would be listed in your transcript. It is an indirect cost just as a large bid-ask spread due to an illiquid stock can be an indirect cost, as you may have to allow for a higher price to buy or a lower price to sell. – user9722 Apr 26 '13 at 1:34
  • @George Bid-ask spread is by itself not a cost. As Joe mentioned in his answer, it can be used to asses current value. But that's mostly useless. Cost is something you pay, and there's no spread to pay in stock transactions. I explained it very well (IMHO) with an example of a transaction that does have an inherent spread cost. – littleadv Apr 26 '13 at 1:45
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    @Joe I'm talking from the perspective of an actual transaction, not a hypothetical "what if". When you're trying to calculate the cost of a transaction, as the OP tries, there's no spread. – littleadv Apr 26 '13 at 3:26
  • @GeorgeRenous: If the highest posted bid is $9.50 and the lowest posted ask is $10.00, then no shares will be traded unless someone posts a higher bid or a lower ask. If someone posts a bid of $10.00 or higher they'll buy shares for $10.00; if someone posts an ask of $9.50 or lower, they'll sell shares for $9.50. If one person posts a $9.75 bid and another posts a $9.75 ask, then they'll sell to each other at $9.75. If at any time the highest bid and lowest ask were equal, then whoever was bidding that amount would buy shares from whoever was offering them at that amount, until... – supercat Dec 29 '14 at 22:12
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As an aside, on most securities with a spread of the minimum tick, there would be no bid ask spread if so-called "locked markets", where the price of the best bid on one exchange is equal to the price of the best ask on another, were permitted.

It is currently forbidden for a security to have posted orders having the same price for both bid and ask even though they're on different exchanges.

Option spreads would narrow as well as a result.

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