Concept
The bid–offer spread for securities is the difference between the prices quoted for an immediate sale (offer) and an immediate purchase (bid). The size of the bid-offer spread in a security is one measure of the liquidity of the market and size of the transaction cost. If the spread is 0 then the security is a frictionless asset.
Signals from dividend policy may give clues about stocks.
The spread measures the cost of executing an instant trade.
Liquidity
The trader initiating the transaction is said to demand liquidity, and the other party (counterparty) to the transaction supplies liquidity. Liquidity demanders place market orders and liquidity suppliers place limit orders.
Limit Order
A limit order is an order to buy or sell a stock at a specific price or better. A buy limit order can only be executed at the limit price or lower, and a sell limit order can only be executed at the limit price or higher. A limit order is not guaranteed to execute. A limit order can only be filled if the stock's market price reaches the limit price. While limit orders do not guarantee execution, they help ensure that an investor does not pay more than a pre-determined price for a stock.
Example
If the current bid price for the EUR/USD currency pair is 1.5760 and the current offer price is 1.5763, this means that currently you can sell the EUR/USD at 1.5760 and buy at 1.5763. The difference between those prices (3 pips) is the spread.
For a round trip (a purchase and sale together), the liquidity demander pays the spread and the liquidity supplier earns the spread. In some markets such as NASDAQ, dealers supply liquidity. However, on most exchanges, such as the Australian Securities Exchange, there are no designated liquidity suppliers, and liquidity is supplied by other traders. On these exchanges, and even on NASDAQ, institutions and individuals can supply liquidity by placing limit orders.
Transaction Costs
The bid–offer spread is an accepted measure of liquidity costs in exchange traded securities and commodities. On any standardized exchange, two elements comprise almost all of the transaction cost—brokerage fees and bid-offer spreads. Under competitive conditions, the bid-offer spread measures the cost of making transactions without delay.