The quoted bid‐ask spread for a security was $47.25–$47.27. A trader with a market order sold the security at $47.26. The bid‐ask spread remained the same before and after the execution. The effective spread for this trade most likely indicates:
an illiquid market.
significant price impact of the trade.
dealers are providing price improvements.
I don’t have any problem in solving the question but not able to understand below-captioned concept provided in the answer to this question. Please help!!!
“In general, if effective spreads are less than quoted spreads, dealers are providing price improvements. In this case, the price improvement may have been for the seller, but the dealer may be crossing orders from several sources, including hidden orders.”
Quoted spreads based on: displayed prices
Effective spreads based on: negotiated prices between client and dealer
When you buy stuff at the supermarket, the supermarket offers multiple sale discounts on its products - this is price improvement to convince you to buy its products. So, if the client is a buyer, he would like to pay the security at, for example, $47.26 instead of the quoted $47.27, because he is paying $0.01 less for each security bought.
Similarly, if the client is a seller, he would like to receive , for example, $47.26 instead of the quoted $47.25, because he is receiving $0.01 more for each security sold.
This is what is meant by “dealers providing price improvements to clients”. If client buys cheaper, and sells more expensive, effective spread will be lower, thus the dealer is making less profits over that client, thus less profits means lower [effective] spread.