If you have ever traded a stock before, you would have come across bid and ask prices. They’re the two stock quote numbers that usually get displayed in green and red. But have you ever wondered or ask what they really are and where they stem from? Why are these two prices different from each other?
Let’s look closely into bid and ask prices and respond to some of these questions. We will also explore some examples.
What is Bid and Ask Price?
The bid and ask price are simply two-way price quote. It shows the best possible price at which a stock can be purchased or sold at a specific time. Stocks are special because their prices are decided by both buyers and sellers.
Ever observed how the bid and ask are always different at every given time? Let’s dissect each piece to figure out the reason.
What Is a Bid Price?
The bid is the highest price that a buyer is offering to pay for a certain stock. If you want to sell a stock, you will have to sell it off at this particular price.
What Is an Ask Price?
The ask is the least price that a seller is offering to receive in exchange for a stock. If you want to purchase a stock, this is the price you will have to pay for it.
What Is the Bid-Ask Spread?
The bid-ask spread is the difference in price between the bid and ask. The spread changes based on the stock and the market. But smaller spreads denotes that the stock is very liquid as a result of the buyer’s willingness to pay close to what sellers are offering. Larger spreads denotes that the stock is in low demand and as a result there aren’t enough buyers to move the price higher.
Examples of the Bid and Ask
Let’s examine a few examples of bid and ask prices from the stock market. This will also provide you with examples of diverse bid-ask spreads.
On March 31, 2020, the SPDR S&P 500 (NYSE: SPY) had a bid price of $254.25 and an ask price of $254.31. At this particular period that day, the maximum a buyer was offering to pay was the lower of the two. And the maximum price was the lowest a seller was willing to take. SPY is a very liquid stock, notice how close the two prices are.
Vertex Pharmaceuticals Incorporated (NASDAQ: VRTX) had a bid price of $237.95 and an ask price of $240.04. See the difference in spread compared to SPY? VRTX doesn’t have near the volume as the SPY. That shows a lesser demand for the stock. Lesser buyers are offering to pay the asking price, hence the wider bid-ask spread.
Cowen Inc (OTCPK: CWGRP): had a bid price of $562.88 and ask price of $850 with a difference of $287.12. This is a good example of a large bid-ask spread, and this indicates that the buyer and seller are in serious disagreement about the value of the stock.
Who Benefits From the Bid-Ask Spread?
The bid-ask spread mostly benefits the market makers. These large organizations quote the bid and ask prices and then make profit from the spread. It’s the money they derive for successfully and rapidly linking up buyers with sellers.
In the VRTX stock example above, the market maker quotes a price of $237.95 (Bid price) / $240.04 (Ask price). In this case, the market maker’s profit would be $2.09.
If a buyer isn’t ready to pay a price above a specific threshold and sellers aren’t ready to reduce their offer, spreads can widen rapidly. So, it is advisable to pay attention to the spread before entering a trade. If you’re not vigilant, you may eventually spend more than you realized.
Types of Orders
Let’s take a look at some of the orders types that traders deal with:
- Market Order: a market order, also known an unrestricted order, is an order that fills at a stock’s recent price. It processes instantly which can be an advantage if you need to get in or out of a stock as quickly as possible.
- Limit Order: a limit order, also referred to as a take-profit order, is an order that only fills at a certain price or better still, during a specific time frame.
- Day Order: a day order is viable only for that specific trading day. The order is canceled if it does not get filled that day.
- Fill or Kill (FOK): an FOK order must be filled instantly and completely or not at all. For instance, if a person were to put in an FOK order to sell 1,000 shares at $10, a buyer would take in all 1,000 shares at that price instantly or rejects the order, in which case it would be canceled.
- Stop Order: a stop order gets triggered when the stock surpasses a certain level. For instance, if an investor wants to sell 1,000 shares of ABC stock, if it trades down to $9. In this case, the investor might place a stop order at $9 so that, as soon as the stock does trade to that point, the order becomes effective as a market order. Note, this does gives an assurance that the order will be executed at exactly $9, but it does guarantee that the stock will be sold. If sellers are sufficient, the price in which the order gets filled might be lesser than $9.
How to choose the right type of Order
As mentioned earlier, a market order executes instantly. The peril with a market order is that you will be in dark as to the price you’ll actually get until your order is filled. If the bid-ask spread is wide, you could end up paying much more than you bid for.
Market orders should be implemented when assurance of execution is more crucial than the price of the execution.
Conversely, limit order won’t fill until you attain a favorable price. For instance, a buy limit order will only be executed at the limit price or lower.
Best Bid-Ask Spread Trading Strategy
Obtaining a clearer knowledge of how the bid and ask operates can transform you into a better trader because you can then leverage your understanding to attain a better price execution.
Purchasing at the ask price or selling at the bid price is referred to as “paying the spread.” To simply put, you’re paying the market maker fee that we discussed about earlier.
The market can move very rapidly, so you may need to pay the spread if you need to get in and out of a position promptly. It isn’t however, always the best choice for all trades. Why? It could immensely affect your profits with time.
Regardless of what you see on the bid and ask prices, you can fix your attention on the time and sales to see where people are placing their money.
No matter how experienced you are as a trader, you are still but a human being. And as such, errors are unavoidable and an area where traders make errors more often than not is at the point of their order execution.
Lastly, it is best to stay away from low volume/large spread stocks.