Ever wonder why there are so many prices of a stock when you look them up in the screen. Isn’t the “last trade price” the price that we should be concerned about? If you wonder about that, this article is for you.
In any market, there are buyers and sellers that want to buy and sell respectively. Buyers puts out a bid price that they are willing to buy it for and sellers offer it for sell at the ask price. Whenever the bid and ask price match, there is a transaction.
The bid ask spread represents the difference between the bid and the ask price. Some securities will have a very small spread (as small as one penny) and others will have very high spreads which generally mean that the security is very illiquid.
For example, a stock ABC with 10 people willing to buy at $5.00 and 3 people willing to sell at $5.02 will have a bid ask spread of $0.02 if there are no bid or ask prices at $5.01. This also implies that it is possible to buy ABC at $5.02 and sell it at $5.00 in this moment in time.
Liquidity and the Bid Ask Spread
While a smaller poll of buyers and sellers doesn’t automatically guarantee that the bid ask spread is larger, it is often the case. This is because the fewer people participating, the smaller the chance that the bid and ask spread will come closer!
The liquidity problem is one of the reasons why market orders are so dangerous. Normally, market orders are routed through the system to match the lowest ask price (when someone buys) and the highest bid price (when someone wants to sell). If there are few buyers and sellers for ABC, the bid and spread price might be as far as $4.50 and $5.50 respectively! While this scenario might be extreme, there are cases where the bid ask spread is even farther apart so take note and never put in a market order again!
The Role of the Market Makers
To increase liquidity, securities often have a market maker that tries to balance the transactions, meaning that they will buy when there’s an excess of sell orders and sell when there’s an excess of buy orders. These market markers used to be called “specialist” as there’s an actual person sitting on the floor of the exchange but as markets have become computerized, so has the market makers.
Scalping the Spread
There is a trading technique known as “scalping” where traders take advantage of the bid and ask spread. The key to scalping is to take small profits in every trade that can add up. The basic example of a scalping strategy is to put in an order to buy at the bid price and another order to sell at the ask price. If the bid ask spread is big enough, even this small difference can cover the trading fees.
One thing of note is that this strategy works best when the security’s price is not fructuating widely. In a highly volatile market, the bid ask price can swing so fast that anyone trying this scalping strategy can be wiped out easily.
What this Means for You and Me
There you have it, the reason why bid and ask prices exists as well as what the bid ask spread means. While this is primarily useful for traders, investors can use this (in addition to the average volume of transactions) to help determine the liquidity of the security.
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This is exactly why you should use limit orders instead of market orders because you might not get the best possible price; you might end up paying more because the seller is selling it higher than you want.
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