Bid and Ask price

The Bid, Ask and Spread in the Stock Market

The Bid:

Simply put, the bid is the price potential buyers are willing to pay for a security.

When a stockholder decides to buy, the person generally sets a maximum price to pay. For example:

You may like a stock that has been trading in the $30 to $32 range throughout the day. If you want, you can enter an order to buy at a maximum of $30.50. This is called a *limit order.

As you know, the stock markets are full of people that are trying to buy and sell at different prices. However, most investors are protected by rules that require their brokers to get the best possible price on a trade. Therefore, the highest price from all the buyers in the stock market is "the bid". So if your bid at $30.50 is higher than everybody else's, your price becomes the "best bid".

Another way to look at this is to use a *market order as an example.

If you wanted to sell a certain stock no matter what the price, you could enter a market order. If you did this, your sale would occur at the best bid in the market - whatever it happened to be when your order reached the bid price.

Typically, the bid and ask are quoted for "round lots" of 100 or more shares. If you want to sell 1000 shares, you may get the quoted bid price for the first 100, and receive lower prices for the rest of your shares. This could be small or large, so be careful.

*
Limit Order

Definition: A limit order is an order with limitations placed on a price.
You're asking to trade at a specific price or better (higher if you're selling,
lower if you're buying).

Limit orders are only executed if the opposing side of the market's bid or ask
reaches your limit price. For example, if you enter a limit order at $30.50,
your order will not be executed unless the bid reaches at least $30.50.

Market Order

Definition: A request to trade securities as soon as possible. A market order
is executed as soon as it hits the market price whatever this price happens to
be. You are guaranteed that your order will be executed. However, your
price may be higher or lower than you expected due to the rapid change in
price during trading hours.
One minute a stock may cost $30 and a minute or even seconds later, the
price may be up or down 50 cents depending on how heavy a security is
being traded.

As an example, suppose that you enter a market order at $31.50 to buy 100
shares of a stock that has been trading between $30 to $35 all day.
When your order then either hits $31.50 or passes $31.50 - above or below,
depending on where the stock was trading when you entered your order -
you will buy at that current ask price, which may or may not be the price you
expected.

The Ask:

Also known as the "Offer", this is the price at which sellers are willing to sell a security. It's the lowest price that all sellers in the market are asking.

When a stockholder decides to sell, that person generally sets a minimum price to accept. For example, you may own a stock that has been trading between $30 and $35 throughout the day. If you want, you can enter a limit order to sell your shares at a minimum of $34.

Here also, investors are protected by rules that require their brokers to get the best possible price on a trade.

So if your offer to sell at $34 was lower than everybody else's, your price would then be the ask. This is sometimes also refered to as the "best ask".

Or, just like the bid, a market order to sell a security can be placed. And here as well, the bid and ask are quoted for "round lots" of 100 or more shares. So if you want to buy 1000 shares this time, you may pay the quoted ask price for the first 100, and pay higher prices for the rest of your shares.

The Spread:

This is simply the difference between the bid and the ask.

When you view security prices on a trading screen, you'll find that these have two quotes - the bid and the ask as already discussed.

Suppose you own 100 shares of XYZ corporation and you want to buy or sell these shares.
You obtain a quotation which indicates that the current bid price is $50 per share and the current ask price is $52 per share.
These quotes mean that someone is willing to buy at $50 and another is willing to sell at $52. The difference between these bid and ask prices is refered to as the spread.

In the above example, the spread is 2 Dollars.

If you were to simultaneously buy and sell XYZ shares at the market price, you would lose $2 per share on the apread.

Another way to describe the bid and the ask is to say that the "bid price" represents the highest price somebody is willing to pay for a security at a particular point in time, whereas the "ask price" is the lowest price at which somebody is willing to sell a security.

Why is there a spread after all?

To compensate for risk. Market Makers seek to buy shares at a low price and sell at a high price. The bid-ask spread is therefore intended to compensate Market Makers for the risk they take in dealing with a security and keeping the market liquid.

The size of the bid-ask spread on a particular security depends on several factors. In general, the more liquid (volume) a security is, the smaller its bid-ask spread will be.

Note that the bid-ask spread is a "hidden" cost for investors. It is a cost that is additional to the normal commissions paid for executing trades.

For frequent traders, the bid-ask spread can rapidly cut into their trading capital. These traders should avoid stocks with inordinately high spreads, particularly when using market orders. It's best to avoid thinly traded securities priced under $5.

Ricky Schmidt

February 13, 2005

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StockBreakthroughs.com > The Bid, Ask and Spread in the Stock Market