Why are small-cap spreads so much wider than large-cap spreads?

Question

A mega-cap stock trades one cent wide with enormous depth. A thinly traded small-cap of similar share price trades fifty cents wide with tiny size.

Using the three components of the spread, explain why the small-cap spread is so much wider.

Accepted Answer

The spread compensates for adverse selection, inventory risk, and order processing. All three point the same way for a small-cap. 1. Inventory risk is far higher. A small-cap is more volatile and, crucially, harder to offload. If you buy 10{,}000 shares of a mega-cap you can hedge or resell almost instantly into deep liquidity. In a small-cap the same position might take days to work out of, during which the price can move a lot. You must be paid more to warehouse a position you cannot quickly exit, so this term dominates. 2. Adverse selection is worse. Fewer eyes and less public information …

Why are small-cap spreads so much wider than large-cap spreads?

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