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The size of the bid-offer spread in a security is one measure of the liquidity of the market and of the size of the transaction cost. The trader initiating the transaction is said to demand liquidityand the other party counterparty to the transaction supplies liquidity.
Liquidity demanders place market orders and liquidity suppliers place limit orders. For a round trip a purchase and sale together the liquidity demander pays the spread and the liquidity supplier earns the spread. All limit orders outstanding at a given time i.
However, on most exchanges, such as the Australian Securities Exchangethere are no designated liquidity suppliers, and liquidity is supplied by other traders. The bid—offer spread is an accepted measure of liquidity costs in exchange traded securities and commodities. On any standardized exchange, two elements comprise almost all of the transaction cost —brokerage fees and bid-offer spreads. Under competitive conditions, the bid-offer spread measures the cost of making transactions without delay.
The difference in price paid by an urgent buyer and received by an urgent seller is the liquidity cost. Since brokerage commissions do not vary with the time taken to complete a transaction, differences in bid-offer spread indicate differences in the liquidity cost. The difference between those prices 3 pips is the spread.
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