The size of the spread from one asset to another will differ mainly because of the difference in liquidity of each asset.
Since the spread is taken away by the dealers, how can it represent the difference in liquidity of the two assets? Market-makers which you term dealers earn the bid-ask spread by buying and selling in as short a window as possible, hopefully before the prices have moved too much.
It is not riskless. The spread is actually compensation for this risk. From The Race to Zero:. The market-maker faces two types of problem. One is an inventory-management problem — how much stock to hold and at what price to buy and sell. The market-maker earns a bid-ask spread in return for solving this problem since they bear the risk that their inventory loses value. Market-makers face a second, information-management problem. This arises from the possibility of trading with someone better informed about true prices than themselves — an adverse selection risk.
Again, the market-maker earns a bid-ask spread to protect against this informational risk. It provides protection against risks from a depreciating or mis-priced inventory.
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The less liquid an asset is, the more time is likely to pass and hence more information likely to arrive until someone comes along to take the inventory from the dealer, and the greater is the risk that the price will have changed in the mean time. Since spread is compensation for this risk, ceteris paribus spreads are wider for less liquid assets.
Every merchant makes money by buying wholesale, and selling retail. In the case of a market maker, the "bid" is the "wholesale" price, and the "ask" is the retail price. In "real life," the difference between wholesale and retail depends on how quickly something sells.
High volume items like gasoline and milk have narrow spreads between wholesale and retail because they sell quickly. Low volume items like furniture and cars sell slowly, and thus have much larger spreads. The same is true for high and low volume stocks. In the case of IBM, the bid-asked spread might be a penny or less.
Other stocks trade only a few thousand shares a day.
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In that case, the spread might be five, ten cents or even more, just to make it worthwhile for the dealer to trade them. Market makers make the spread on market orders, only. The market maker is buying the market-sells at the bid and selling the market-buys at the ask.
If the market-buy volume equals the market-sell volume then the market maker is just transferring shares between market-buyers and market-sellers and pocketing the the bid-ask spread in addition to commissions. Limit-buy orders are filled when limit-sellers drop their asking price and limit-sell orders are filled when limit-buyers raise their bid.
The market maker makes only commission on limit orders but limit orders define the bid-ask spread. Thank you for your interest in this question. Because it has attracted low-quality or spam answers that had to be removed, posting an answer now requires 10 reputation on this site the association bonus does not count. Would you like to answer one of these unanswered questions instead? Sign up or log in to customize your list.
Stack Exchange Inbox Reputation and Badges. Questions Tags Users Badges Unanswered. Join them; it only takes a minute: Here's how it works: Anybody can ask a question Anybody can answer The best answers are voted up and rise to the top. How does a dealer or market maker earn the bid-ask spread on a stock? If I am correct, dealers purchase assets for their own accounts, and later sell them for a profit from their inventory.
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But the spreads is the difference between buy or "bid" prices and sell or "ask" prices at the same time. So how can dealers earn the bid-ask spread? Tim 2, 10 38 From The Race to Zero: Tal Fishman 2, 7 Do they actually make the markets?
Tim 3 Dealers typically serve a market-making function though sometimes they are dealing in products which they also originate , and certainly not all market makers are dealers. Your statement regarding spreads applies to dealers doing market-making, and also non-dealer market-makers. Tim Not sure what is your question about 1 , seems pretty clear to me.
For 1 , I am not clear why spread can be compensation for the risk. Tom Au 5, 12 While it's normally a bit weird to answer an already answered question from 3 years ago, in this case I think your answer is better than either of the other two. But it still has some errors that prevent me from upvoting it. Perhaps I'm just nitpicking semantics, but it is not the case that market orders are the only kind of orders that cross the spread; you can certainly send a limit buy at the current ask while the rest of the bid side of the market stays where it is.
This looks like a market order but is not the same thing. Rea Mar 1 '16 at MathOverflow Mathematics Cross Validated stats Theoretical Computer Science Physics Chemistry Biology Computer Science Philosophy more 3. Meta Stack Exchange Stack Apps Area 51 Stack Overflow Talent.