What is the effective spread and how is it different from the quoted spread?

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AcadiFi · Accepted Answer

Quoted spread = ask - bid at time of trade. It's the advertised round-trip cost if you cross both sides. Effective spread = 2 * |P_trade - midpoint|. It measures the actual distance from midpoint paid by a trader. For trades executed inside the spread (price improvement), effective spread < quoted. For trades that cross a wide spread or get filled outside, effective can equal or exceed quoted. Realized spread = 2 * |P_trade - midpoint_t+5min|. Measures the portion of the effective spread actually earned by the liquidity provider AFTER the market has moved in response to the information in the trade. Realized = effective - price impact. Example: Cascadia Minerals, bid $40.00, ask $40.10, mid $40.05 (quoted spread = $0.10 = 25 bps). Trade executes at $40.09 (buyer crosses). Effective spread = 2 * |40.09 - 40.05| = $0.08 = 20 bps (some price improvement inside quote). Five minutes later, mid is $40.08 (market moved up on the buy). Realized spread = 2 * |40.09 - 40.08| = $0.02 = 5 bps. The other 15 bps is price impact reflecting information the trade revealed. ```mermaid flowchart TD A[Quoted Spread
ask - bid] --> B[Before trade] C[Effective Spread
2|P - mid|] --> D[At trade] E[Realized Spread
2|P - mid_t+5|] --> F[After market adjusts] D --> G[Price Impact = Effective - Realized] ``` Use cases: regulators and researchers prefer effective spread for transaction cost analysis because it reflects real execution quality. Market-maker P&L is tied to realized spread — their gross revenue net of adverse-selection bleed. Investors evaluating brokers care about effective spread — how much they actually paid, not advertised quotes.

What is the effective spread and how is it different from the quoted spread?

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