Quick definition The effective spread is the difference between your actual execution price and the market midpoint at the moment you executed. What it is The market shows bid 100.50, ask 100.51. The midpoint is 100.505. You execute a market buy at 100.51. The effective spread is 100.51 - 100.505 = 0.005. Effective spread measures the true cost of executing, not just the quoted spread. It accounts for the fact that you execute away from the midpoint. Why it matters Effective spread is the trader's perspective. You care about your actual execution price relative to the market midpoint. Effective spread measures this. Effective spread also accounts for market impact. If your large order moves prices, the effective spread widens. Effective spread versus quoted spread Quoted spread: bid-ask spread published by the market maker (0.01 in the example). Effective spread: difference from midpoint (0.005 in the example). If you execute perfectly at the midpoint, effective spread is 0. In reality, you execute at the ask (for buys) or bid (for sells), so effective spread is half the quoted spread or more (if there's market impact). Market impact on effective spread Large orders may move prices, increasing the effective spread. A 1 million-share order might have a larger effective spread than a 100-share order in the same stock. Practical example You want to buy. The market is bid 100.50, ask 100.51, midpoint 100.505. You execute 100 shares at 100.51. Effective spread is 0.005 (you paid 0.005 above midpoint). You then execute 100,000 shares. The price moves as you buy; your average price is 100.65. The effective spread is now 0.145 (you paid 0.145 above the original midpoint). Measurement Effective spread is calculated as: Effective spread = 2 * |Price - Midpoint| * Sign Positive values indicate you paid more (buying) or received less (selling). See also - Bid-Ask Spread - Realized Spread - Market Impact - Execution Cost
