Liquidity has two sides:
demand and supply. Any trader who wants to buy/sell security immediately is
demanding liquidity, therefore he places market order. Counter-party to his
transaction is supplying liquidity, through limit orders. Bid-ask spread is considered
liquidity cost in any standard security exchanges because of two reasons:
- It is an urgent round trip (buy and sell immediately without any delay) cost paid by market cost.
- One other way to consider bid-ask spread a transaction cost is marked to market nature of markets. For example: If you buy at $100 and at the end of day if best bid price is $99, then you have lost $1 already without selling it.
Bid-ask spread and
impact cost are indirect transaction costs in markets, paid by liquidity
demanders to liquidity suppliers. For small transactions bid-ask spread and for
large market moving transactions impact cost is measured as indirect cost of
transactions. Direct costs (Brokerage and commission) are known but indirect
costs (spread and impact cost) are unknown, therefore traders pay close
attention to them. Bid-ask spread is different from bid-ask bounce.
