There are different liquidity metrics and in this article of QuantVan Academy, we are going to explain Bid/Ask Spread.
Bid/Ask Spread as a liquidity metric
Bid-Ask spread is one of the most common liquidity metrics. The bid-ask spread is the difference between the highest price that a buyer is willing to pay and the lowest price that a seller is willing to accept.
A large spread decreases liquidity.
This is due to the simple fact that the price at which buy and sell orders become executable needs to cross the spread bringing about an increase in execution cost.
Market makers usually try to place orders inside the gap in order to increase the liquidity for traders, however, the gap is normally a result of a fundamental understanding of an increase in the asset risk. The probability of execution for the orders placed inside the gap is high which forces the market maker to place orders with lower quantity or frequency.
The Bid/Ask spread ( (Ask – Bid)/Bid ) KPI is easy to calculate and easy to compare:
When the ratio decreases, the pair is becoming more liquid.
The ratio itself has value and can be compared amid two pairs or one pair in two exchanges.
Some of the key elements to the bid-ask spread include a highly liquid market in order to ensure an ideal exit point to book a profit. Secondly, there should be some friction in the supply and demand for that security in order to create a spread. Market Maker should use a limit order rather than a market order; meaning the Market Maker should decide the entry point so that they don’t miss the spread opportunity.
The following image is the bid/ask spread gap for TRX/ETH in three major exchanges: Binance, hitbt, and LATOKEN
Traders some times consider The bid-ask spread a measure of the supply and demand for a particular asset.
The bid can represent demand. The ask can represent the supply.
Thus, when these two prices expand further apart the price action reflects a change in supply and demand.