For new investors starting out, it is important to have a full understanding of the stock market. Consider the stock market to be like an auction. It is a place where investors (who can be individuals, corporations, even governments) buy and trade securities.
When they are buying and selling different securities, it does not follow the same set price as traditional consumer purchases. Instead, buyers and sellers set the stock prices. In this article we will dive into the importance of bid and ask prices are when investing.
What Is a Bid Price?
There are two parties involved in buying and selling a security – the buyer and the seller. The bid price is the maximum price that the buyer (investor) is willing to pay for the stock.
What Is an Ask Price?
The other party involved, the seller, then has a minimum price that they are willing to sell the security for. This is called the ask price.
What Are the Key Differences Between Bid & Ask?
Let’s start with an example. If an investor wants to buy 100 shares of stock in Company A for a maximum of $1,000 their bid price would be set at $10 per share. To make the purchase, a seller would have to have an ask price at $10 per share. It is only then that the transaction can take place.
Typically, the bid price will always be lower than the ask price. The reason for this is that an investor will not sell their security (ask price) for lower than what they are willing to pay (bid price).
Liquidity is the ease that a security or asset can be converted to cash, without an impact to its market price. When the bid price and ask price are close together, the security has a greater liquidity.
How Are Bid & Ask Prices Chosen?
The market is full of buyers and sellers. The current stock price, also known as market value, is the price the stock was last traded. It is a historical figure that does not reflect the current bid price.
These prices are different and represent the value that current buyers and sellers are willing to trade at. If there is demand for a security that outweighs the supply, the bid and ask prices will gradually rise. Alternatively, if there is higher supply than demand, the bid and ask prices will trickle downward.
What Is a Bid-Ask Spread?
When thinking about bid-ask spread, you should first consider supply and demand. Supply is the volume of a particular item in the marketplace, like a stock that is being traded. The demand is an individual’s willingness to pay a specific price for that item. This spread is the difference between the bid price and the ask price of the specific security.
Examples of Bid-Ask Spread
If the bid-ask spread for a share in Company B is $12/$12.05, the spread is $0.05. This means the buyer is willing to pay $12 and the seller is willing to accept $12.05.
An investor who is looking at the bid-ask spread knows that if they want to sell their shares in Company B that they could do so by selling at $12 per share. An investor who is looking to buy shares of Company B could purchase them at $12.05.
Who Benefits From It?
The market maker is the one who has the advantage from the bid-ask spread. A market maker is an individual or firm that actively quotes two-sided markets in a security – bids and asks. If they are quoting the example above $12/$12.05 for Company B, the spread is what the market maker has in profit.
What Does It Mean When the Bid Price & Ask Price Are Close?
When the bid price and the ask price are close, it means there is a tight bid-ask spread. This indicates that the security is actively traded with good liquidity.
However, if there is a wide bid-ask spread it can signal the opposite. A significant imbalance in the bid-ask spread usually signals that there is an imbalance in supply or demand.
Bid-Ask Spread & Order Types
While bid and ask prices might seem straightforward, there are different ways that you can place orders on the market while utilizing the bid-ask spread.
The most popular order is the easiest to understand. There are buy and sell orders that have the intention of being traded immediately. They are filled at the most favorable opposing price until the full quantity within the order is filled.
A stop order is a conditional order that becomes a market order when a specified “stop price” is reached. A stop-limit order is a conditional order that becomes a limit order when a specified “stop price” is reached.
Investors can use limit orders to buy securities at a price that is better than the current price. For example, they can set a limit order for 1000 shares of stock in Company B for $12 while the ask price is still $12,05. The order will not be placed until the price of the stock drops to at least $12.
This example of a limit order would work in reverse for a seller. If the current ask price is $12.05, they can set a limit order to sell once it reaches $12.10. This order will not be fulfilled until someone is willing to pay $12.10 per share.
How To Utilize Bid-Ask Spreads
Every trade includes a buyer who is willing to pay a specified price, and a seller willing to take that price. No matter which role you play in the trade, you should utilize bid-ask spreads to your advantage.
The best way to do so is to understand the role it plays with supply and demand. If you can see the supply or demand outpacing each other when you review the bid-ask spread, you can find excellent trade options that can increase your wealth.
Financial Advisor Can Help Bid-Ask In Fast-Paced Market
The market moves at a rapid pace. Investors are bidding and offering different quantities and prices of securities. Others are doing the opposite and asking to sell their stock.
Understanding which type of market order you should use to buy or sell your securities can seem daunting. But there is no need to worry when you have a trusted financial advisor by your side. They can guide you through the process to ensure your orders run smoothly and that you are selecting the best stocks for your portfolio.