Bid-Ask Spreads: Effective versus Quoted
The quoted bid/ask spread is the difference between the lowest ask price for a security and the highest bid price. For small orders, the quoted spread is a good indication of the execution cost for a trade. For large orders, however, it may not fully represent the cost.
The effective spread better captures the cost of a round-trip order by including both price movement (dealers coming in to execute orders at a better price than previously quoted) and market impact (spread widening due to the size of the order itself.)
Effective spread is defined as twice the difference between the actual execution price and the market quote at the time of order entry. For example, an order is entered when the quote is $10.00/$10.20. The order is executed at $10.15. The effective spread is 2(10.15 – 10.10) = $0.10.
For more information, see all articles on: Active Management, Institutional Investing, Investing in Stocks, Investment Returns, Portfolio Management, Risk Management, Trading Execution See also:
The Intelligent Investor: The Classic Text on Value Investing
Financial Statement Analysis: A Practitioner's Guide, 3rd Edition
Managing Investment Portfolios: A Dynamic Process (CFA Institute Investment Series)
