4

I want to know why when we calculate the spread equation, that is the difference between ask rate and bid rate divided by ask rate, why can't we divide by bid rate?

7

Mathematically it's arbitrary - you could just as easily use the bid or the midpoint as the denominator, so long as you're consistent when comparing securities. So there's not a fundamental reason to use the ask.

The best argument I can come up with is that most analysis is done from the buy side, so looking at liquidity costs (meaning how much does the value drop instantaneously purely because of the bid-ask spread) when you buy a security would be more relevant by using the ask (purchase price) as the basis.

Meaning, if a stock has a bid-ask range of $95-$100, if you buy the stock at $100 (the ask), you immediately "lose" 5% (5/100) of its value since you can only sell it for $95.

  • Your last paragraph is spot on. My wife does arbitrage (with antiques) and we often here people say something like "well, everything has a price!!" What they fail to realize is everything has two prices - one you buy at, and one you sell at, and if you haven't thought about what both of them are going to be, you're in for a world of hurt. – corsiKa Oct 30 '17 at 21:24

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