Updated Jan 22 2021
The Bid is the maximum price at which buyers are willing to buy an asset, the Ask is the minimum price at which sellers are willing to sell an asset and the Spread is the difference between both Bid and Ask prices.
When you see any trading chart and read that the price of a stock is $119.5, you may be not looking at the Bid or Ask price. If you execute a market order you could end up getting a completely different price as the price in the chart could have been the current bid price, the current ask price, a medium of both or the price of the last transaction executed.
It is extremely important in any trading platform to set your charts to look at the specific price you care about, either the bid or the ask.
Some trading platforms will allow you to view the bid and ask in several ways, for example:
The spread is the difference between the bid and ask prices. Market makers set the spread as their compensation for the risk of constantly fulfilling incoming buy and sell orders to maintain market prices, for example: a market maker could have just fulfilled your buy order and immediately the price jumps a few cents causing them a loss.
That's why the spread gets created and you're always buying at a more expensive price or selling at a lower price, this is how market makers profit from providing liquidity (availability of an asset).
Imagine for a second that we want to initiate the market for a particular asset, let's say a stock.
The moment we launch our IPO (initial public offering) and start throwing stocks into the market for traders to buy, we have a problem.
There is no flow in both directions that can maintain a steady price as it's just us selling stocks and people buying, so how can we create a market for a stock from scratch?
We need a lot of traders buying and selling constantly for the market to stabilize and that's when market makers come into play.
Market makers are there to constantly buy or sell the stock to maintain the market price and let the natural forces of supply and demand take place and determine prices over time.
All of this works at a very nice profit for market makers as what they do in simple words is marking up prices at a fee (the spread) in exchange for providing liquidity. Here's how they do it:
As soon as the market is made and there is a lot of participants trading or maybe even other market makers competing to offer their services, there is so much liquidity that the risk of holding that asset and fulfiling orders becomes lower and this causes spreads to become narrower. All of this means that:
Bear in mind that we just described the market making process for standard securities, in the particular case of CFDs there are some differences:
CFD brokers that hedge their transactions (meaning that they take the underlying position of your trade in the real market) are also subject to the same market spreads which they pass on to you
Those spreads can be narrowed or widened on purpose by your CFD broker if they choose to do so as their risk management tool to fulfill your CFD orders.
A good example of this can be: the spread on the market can be $0.1 and your CFD broker is giving you a spread of $0.5. This is not necessarily bad as maybe the CFD broker is taking the risk to fulfill an order that you sent that wouldn't have been possible to fill in the real market as there was no liquidity, they're taking the risk to fulfill you.
Spreads widen due to lack of liquidity and the last one happens due to major price swings, limit orders being removed and market participants not submitting market orders. This causes market makers during their competitive battle for pricing to also widen their spreads to mitigate the risk of a loss while fulfilling orders.
Good luck and happy trading!