To execute trading of portfolio, constituents of which are Small Cap stocks, requires understanding of the Liquidity Risk and Transaction Cost associated with each constituents of the portfolio. Investors should not underestimate the indirect costs associated with liquidity and the the Bid/Ask Spread. In times of low liquidity, many investors rely on the dealers, or market markers for the provision of liquidity. 1 Bondarenko (2001), decomposes the Bid/Ask Spread into two components, Adverse Selection & Imperfect Competition, in which he argues that market makers post prices that are steeper than efficient prices, which then becomes the source of their profit.
Bid/Ask Spread is the difference between the highest price (Ask) and investor is willing to sell its securities and the lowest price (Bid) at which the investor is willing to buy its securities. One of the determinants for this Spread is the Volume of shares traded. Intuitively, it makes sense. Consider an example when the market has less number of shares of a Security “A”. This Security A is considered illiquid, which implies, lesser people trading the security at a particular point in time. Because it is more difficult for the market maker to convert this Security A to cash, the broker needs to compensated more, thus adding to the Bid/Ask Spread and Transaction Cost.
It is thus safe to say that market efficiency and quality could be estimated by means of how narrow the Bid/Ask Spreads are. There has been no dearth of literature on measuring the efficiency and quality of markets through the Bid/Ask Spreads. In fact overreaction and under reaction in markets, both of which are market inefficiencies, have often widened the Spreads in markets. 2 This implies that using Bid/Ask Spreads to is indeed a theoretically correct and practically sane method of measuring market efficiencies.
Let’s go back to the example of Security A. Let’s say that the current Bid price is $5 and the current Ask price is $5.05, the the Bid/Ask Spread of Security A is approximately 0.9% of the current Ask price. The implication of this spread is that the investor loses 0.9% (1%) of the value of Security A as soon as he/she buys (short sells) the Security.
For the purpose of implementation and choosing the constituents of our portfolio from a liquid and an efficient market, we study the behavior of bid/ask spread as a percentage of average mid-price intraday of present 500 constituents of Nifty 500 with respect to turnover and market capitalization. We conclude that the smaller the stocks, the more the transaction cost. Similarly, we find a linear relationship between the turnover of the stock and the average bid/ask spread.
In the Figure above, we notice that the average Bid/Ask Spread as a percentage of the Mid-Price (average intraday) of NIFTY500 constituents is a decreasing function of Volume, implying that higher trading volume comes with tighter spreads and better quality in Market Microstructure.
The figures above indicate the bid/ask spread percentage for the Smallest 100 stocks and the Largest 100 stocks from the Index of 500 stocks. We noticed a high disparity between the bid/ask spread of Largest 100 and Smallest 100 stocks in the Nifty 500 index. We also studied the bid/ask spread percentage from October 13, 2017 to November 13, 2017 and found that for Top 100 and Bottom 100 Stocks, the bid/ask spread percentage did not move much for this period, which had neither any inclusion nor exclusion of stocks to the index.
Due to unavailability of intraday data for stocks other than those in Nifty 500 Index, we could not conduct the same test for stocks outside of Nifty 500 Index. However, as discussed above, to be considered for the index, the constituent has to be in the top 800 rank based on the average daily turnover and average full market capitalization. Moreover, given that the constituents of Nifty 500 (500 out of more than 1600 stocks) represent 95.2% of market capitalization of National Stock Exchange, it is safe to assume that the stocks that are not a part of the index may have a higher bid/ask spread percentage on an average and may also be less liquid because of their size and low trading activities.
Another important determinant of Bid/Ask Spread is volatility. Many studies (Chordia, Roll, and Subhramanyam, 2000, 2001, 2002) 3 find that higher liquidity is generally associated with lower volatility and Transaction Cost 4. This makes sense intuitively, as volatility usually increases during a rapid decline or advancement of market, in which case market makers step in to take advantage of - and profit from - the change. As the price of a security advance increasingly, more investors are willing to pay a higher price for the security enabling the market maker to charge a higher (premium) than efficient price on the security.
Footnotes
Bondarenko, Oleg (2001). Competing Market Makers, Liquidity Provision and Bid-Ask Spread , Journal of Financial Markets, 4, 269-308
Allen B. Atkins and Edward A. Dyl (1990), Price Reversals, Bid-Ask Spreads, and Market Efficiency, The Journal of Financial and Quantitative Analysis, 25(4), 535-547
Chordia, Tarun, Roll, Richard and Subrahmanyam, Avanidhar, (2002), Order imbalance, liquidity, and market returns , Journal of Financial Economics, 65, issue 1, p. 111-130.
Li, J., & Wu, C. (2006). Daily Return Volatility, Bid-Ask Spreads and Information Flow: Analyzing the Information Content of Volume, Journal of Business, 79(5), 2697-2739 doi:10.1086/505249