Investing in the stock market is easier now more than ever; however, it’s important to know the terms. One thing you should learn is the difference between the bid/ask price. What are the differences between the bid vs ask price?
The “bid” is the term used to describe the highest price a trader intends to pay for a security. Meanwhile, the “ask” is the lowest price the seller intends to receive for the said security. The difference between the bid and ask is the “spread.” The rule of thumb is that the smaller the spread of a certain security, the greater its liquidity.
Read on to learn more about the difference between ask vs. bid price.
Bid vs Ask Price
Bid and ask are the terms used to describe the prices that a stock can be sold and bought. The bid is the maximum amount that a buyer will pay for a certain share of stock, while the ask is the lowest price that the seller is willing to sell the said share of stock.
A trade happens when either the buyer agrees to pay the best price offered or if the seller accepts the best bid that the buyer offers.
The bid-ask spread is the difference between the ask vs. bid prices. The spread is also a good indication of whether a certain stock is liquid or not. In layman’s terms, the narrower the spread, the higher the demand for that stock, and the inverse is true when the spread is large.
Liquidity refers to the efficiency or ease with which one can convert security or asset into ready cash without affecting their market price. The most liquid asset of all is cash itself.
The History of Bid and Ask Spreads
Traditionally, markets are places where sellers and buyers converge to conduct transactions. Even during ancient times, traders came from far and wide to gather in a town market. They did this to conduct trades for goods that they made or gathered.
Modern financial markets have evolved from the old-timey markets. However, note that they still function the same way. Instead of actual marketplaces, modern traders gather in stock markets. Also, instead of physical goods, they trade in promises and financial claims.
Regardless if it is an open-outcry market, like the old stock exchanges or an electronic market that works entirely online, the concept of the bid-ask spread is one of the most important parts of trading.
So what is the difference between the bid and ask? The “bid” is the term used to describe the highest price a trader intends to pay for a security. Meanwhile, the “ask” is the lowest price the seller intends to receive for the said security. The difference between the bid and ask is the “spread.”
What Does the Bid Price Vs Ask Price Represent on a Stock Quote?
Before an investor can start to trade, they need to contact their broker to place an order. How the trade will proceed will vary depending on what type of order the broker placed. Typically, the process involves the broker submitting the client’s offer to a stock exchange.
Every purchase offer will include the number of shares the investor requested and the purchase price he proposed. The highest proposed price is henceforth called the “bid.” It represents the demand side of the market. This means that it is the price that buyers are eager to pay for that particular stock.
On the other side, with every offer to sell comes several stocks offered and a proposed selling price for it. The lowest selling price proposed is henceforth called the “ask.” It is representative of the supply side. To fill an order to buy, the ask needs to match a corresponding bid.
Unless an order crosses the bid-ask spread, no trades will be happening between brokers. In this situation, trading firms called market makers would quote both bid and ask amounts when no orders bridge the spread. This is important to maintain functioning markets.
For instance, Company A has the best bid at 100 shares for $9.95, and the current best ask is for 200 shares at $10.05. Unless the buyer agrees on the ask or the seller agrees on the bid, you can’t expect any trade to take place.
Now, if a certain investor places an order for 100 shares of Company A, the bid would become $10.05. Shares will also exchange hands until the order is filled. After trading 100 shares, the bid will go back to the next highest amount, $9.95.
Market Makers and How They Benefit from the Bid/Ask Spread
To raise the number of market transactions and increase the liquidity of stocks, markets would typically appoint a “market maker” firm to them. This firm’s responsibility is to promote transactions of the stock or security.
If no one is making a bid on it, the market maker will. If there are no offers, the market maker will do it. In short, market maker firms are playing both sides, supplying both the bid and the ask price.
For instance, if a stock is trading for $20, the market maker will ask for $20.10. They will also put down a bid of $19.90. This is known as “calling a market” of $19.90 to $20.10. The $20 trading point will be the “mid-market” price.
This essentially means that buyers will need to pay $20.10, and the sellers need to settle at $19.90. The difference, or the spread, goes to the market maker. Now, this might seem a bit unfair, but it is essentially how trading markets receives liquidity.
The market maker would assume the risk that a buyer would not be showing up for the stock they promised to buy. If this happens, the market maker would then have a position in the stock in their inventory.
The more illiquid a certain stock is, the wider the spread and the bigger the risk. However, it also means bigger compensation for the market maker if the trade pushes through.
Again, what is the difference between bid vs ask price? The bid price refers to the maximum or highest price a buyer is willing to pay for a stock share or security. Meanwhile, the ask price refers to the minimum price a seller is willing to receive for said share or security.
The Bid/Ask Spread
Stock exchanges are configured to assist brokers and other financial experts in coordinating the bid and ask prices. As mentioned earlier, the bid is the highest amount that the buyer is eager to shell out for a particular stock.
On the other hand, the ask is the lowest price that the seller is willing to settle for to part with the stock. The difference between the two prices is the spread.
If the bid price vs ask price is close, the seller and the buyer share a similar opinion on the value of the stock. Now, if the spread is significantly large, it means that the buyer and the seller have widely varying appraisals of the stock’s value.
Typically, the ask price vs. bid price is always close to each other, with the ask higher than the bid. The spread is indicative of the amount of profit that the broker handling the trade can make.
The spread is the representation of the supply and demand for assets, including stocks. The bids represent the demand, which is how much investors want a certain stock. The ask, on the other hand, represents the supply side. It refers to the number of stocks the sellers have and the price they are willing to sell them for.
If the spread is too wide, then it means the buyer and seller are in serious disagreement on the security or stock valuation. This typically translates to the fact that no trades will ever happen.
Liquidity and the Bid/Ask Spread
Several factors contribute to the bid-ask spread. The most evident out of all these factors is liquidity. Liquidity is the volume or number of shares that exchange hands every day. Some stocks get traded almost the entire day. Others, on the other hand, only get traded a couple of times, if that. The former is more liquid than the latter.
Stocks and indexes with large trading volumes will typically have narrower bid-ask spreads than those not traded frequently. A stock that has a low trading volume is considered illiquid.
The reason is that it is quite difficult to convert to cash. Because of the additional difficulty in handling the transaction due to the widespread that they must work with, the broker will require a larger compensation.
Volatility and the Bid-Ask Spread
Volatility is yet another important aspect affecting the bid-ask spread. There is typically an increase in volatility during times of rapid market decline or growth. During these periods, bid-ask spreads become wider. It is mainly because of the market makers who want to profit from the sudden uptick or fall of the market.
When stocks and securities rise in value, investors become more willing to purchase them even at the current high prices. This is in their belief that they would still rise in value. This allows the market maker firms to charge higher premiums from their clients.
On the flip side, when volatility is low, and there are lesser risks and uncertainty, bid-ask spreads are narrower. The reason is that both sides of the demand-and-supply equation are in almost perfect agreement.
Stock Price and the Bid-Ask Spread
The price of a certain stock will also influence its stock bid vs. ask spread. Typically, if a stock’s price is low, the spread tends to be wider because of its perceived liquidity.
Most, if not all of the lower-priced stocks and securities are either from startup companies or small companies (in terms of their workforce). There is only a limited number of these stocks that can be traded, therefore making them illiquid.
In the end, the bid-ask spread will all depend on the supply and demand for that certain stock. In other words, the higher the demand and the fewer the supply, the narrower the spread will be.
Types of Orders and How the Bid-Ask Spread Affects Them
1. Market Order
When buyers go into the market to place an order, there are many options to choose from. One of these is the market order, which means that the buyer will take the best offer once placed.
2. Limit Order
There is also the limit order, wherein the buyer places a ceiling on the amount they are intended to spend for the transaction to push through. Limit orders will only commence if the limit price is still available.
3. Stop Order
On the other hand, a stop order is a conditional order where it can become either a market or a limit order if security reaches a pre-determined price. The market cannot see this type of order. It is, therefore, unlike the limit order, which is visible once placed.
All of these orders contribute to the bid-ask spread. For instance, the market order can contribute to making the bid-ask spread narrower. The reason is that the buyer is willing to accept the best price for the transaction. You must be aware that your strategy and the amount of risk you find acceptable will ultimately affect the kind of bid-ask spread you can take.
The Bottom Line
The bid-ask spread or the difference between the bid size vs. ask size is technically a form of negotiation between the buyer and the seller. Many compounding factors can affect the size of the spread.
By understanding them, traders will be able to make better and more informed decisions regarding their investments. This will also limit the amount of risk involved in their transactions.
Conclusion – Ask vs Bid Price
The bid is the highest amount that a trader wants to pay for a certain stock or security. The ask is the lowest price that the stock seller wishes to receive as payment for it. The ask will always be higher than the bid. The difference between the two amounts is called the “spread.” The smaller the spread, the more liquid the stock is.
The stock market is full of risks, but that should not discourage you from getting into it. You cannot completely get rid of the risks. However, you can manage them not to get hit quite as hard if a trade does not go your way.