Bid-Ask Spread, Depth, and Liquidity
The spread is the price of immediacy: what you pay to trade right now rather than waiting.
For a round trip you pay it once, so a common shorthand is that the cost of trading immediately is half the spread each way.
What sets the width
A market maker sets a spread wide enough to cover four things:
Adverse selection. The risk that whoever trades with you knows more. This is usually the largest component and it rises sharply around news.
Inventory risk. Once filled you hold a position, exposed to price moves until you can hedge or unwind. More volatile instruments therefore carry wider spreads.
Order processing costs. Exchange fees, clearing, technology.
Competition. More market makers competing on the same instrument compresses the spread toward the cost floor.
This decomposition explains the patterns you see. Liquid large-cap stocks trade at a penny wide because competition is fierce and adverse selection is low relative to volume. An illiquid small cap can be dollars wide because any given trade might be informed and the position is hard to exit.
Spreads widen when uncertainty rises, and they widen most when they are least convenient. Liquidity is at its worst exactly when everyone wants to trade, which is a feature of the mechanism rather than a failure of it.
Depth is the other half
Spread describes the cost of a small trade. Depth, the quantity resting at each level, describes what happens to a large one.
Two instruments can both quote a one-cent spread while one has 10,000 shares at the touch and the other has 100. The second offers a headline price that is nearly meaningless for real size, since a 1,000-share order will walk several levels.
This is why sophisticated participants quote effective spread rather than quoted spread:
which measures what you actually paid, including the impact of walking the book. For large orders it is routinely several times the quoted spread.
Three dimensions of liquidity
A useful framing when comparing markets:
Tightness: how wide is the spread? The cost of a small trade.
Depth: how much size is available? The cost of a large trade.
Resilience: how fast does the book refill after a trade? The cost of a series of trades.
A market can score well on one and badly on another. Many electronic markets are tight and shallow: excellent for retail-sized orders, expensive for institutional ones.
Liquidity is conditional
The most important practical point. Liquidity is not a fixed property of an instrument; it is the current willingness of market makers to quote, and that willingness evaporates under stress.
When volatility spikes, spreads widen and depth thins simultaneously, so the cost of trading rises in both dimensions at once. Any risk model treating liquidity as constant will understate the cost of exiting in exactly the scenario where exiting matters.
"How liquid is this?" has no answer without "at what size, and under what conditions?" A position that is easy to exit on a calm Tuesday can be impossible to exit during a shock.
This conditionality is also an opportunity: market makers earn their widest spreads precisely when risk is highest, which is fair compensation for providing a service nobody else will provide at that moment. See spread widening.