The effective bid-ask spread is the difference between the price at which a dealer (or a market maker) buys (sells) a security/investment and the price at which the dealer subsequently sells (buys) it. In calculation, it is twice the absolute value of the difference between the actual trade price and the midpoint of the market quote (i.e., between the quoted bid price and the quoted ask price), divided by the midpoint between these two prices. In equation form, this spread is given by:

Effective spread = 2 (trading price – midpoint of market quote at time of order)

Also, it is sometimes expressed as

Effective spread = 2 (transaction price – mid price)

Suppose the quoted bid and ask prices were $25.45 and $25.50, respectively. Also suppose the ask price at order execution was $25.48. Then, the quoted bid-ask spread is

$25.50 – $25.45 = $0.05

The midquote is ($25.50 + $25.45)/2 = $25.475

Therefore, the effective spread is:

Effective spread= 2 ($20.48 – $25.475) = $0.01

The effective spread is less than the quoted spread by ($0.05- $0.01 = $0.04). This observation is known as the price improvement because there existed an effective spread that is narrower than the quoted spread.