What is the formula for calculating the effective spread?

The effective spread provides a measure of the cost of trading in relation to the midpoint of the bid-ask spread, which represents the fair market price of a security. The effective spread formula takes into account the actual execution price of the trade compared to the midpoint price, and it is specifically designed to capture the implicit costs associated with trading.

The calculation uses the absolute difference between the actual execution price and the midpoint, then multiplies this difference by two. This approach effectively doubles the spread cost, accounting for both the buy and sell sides of the trade, which reflects the total cost incurred by the trader.

Using the midpoint ensures that the calculation is grounded in the market's perception of fair value, providing a clearer picture of the trading costs beyond just the explicit commissions or fees. This makes the effective spread a particularly useful metric for evaluating the efficiency of trade execution.

Understanding this context behind the effective spread provides insight into trading costs and helps investors and analysts gauge market liquidity and trading performance.