The Basics of the Bid-Ask Spread

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The Basics of the Bid-Ask Spread

The phrase spread, or bid-ask spread, is important for stock market investors, but many individuals are unfamiliar with what it means or how it applies to the stock market. The bid-ask spread may influence the price at which a buy or sell is made, and hence the total portfolio return of an investor.

Key Takeaways

  • The bid-ask spread is heavily influenced by liquidity—the narrower the spread, the more liquid the stock.
  • When an order is made, the buyer or seller agrees to buy or sell their stock at the agreed-upon price.
  • Varied order types result in different order positions. Some order types, such as fill-or-kill, state that if the specific order is not available, the broker will not fill it.

Supply and Demand

Before understanding about the spread, investors must first comprehend the notion of supply and demand. The amount or quantity of a certain commodity in the marketplace, such as the supply of stock for sale, is referred to as supply. The readiness of a person to pay a certain price for an item or stock is referred to as demand.

The bid-ask spread so indicates the levels at which buyers will purchase and sellers will sell. A narrow bid-ask spread might suggest that an asset is frequently traded and has strong liquidity. A broad bid-ask spread, on the other hand, may suggest the inverse.

The bid-ask spread will widen significantly if there is a severe supply or demand imbalance and poor liquidity. Thus, popular securities (e.g., Apple, Netflix, or Google shares) will have a lesser spread, while a stock that is not often traded may have a bigger spread.

An Example of the Bid-Ask Spread

The spread is the difference in price between the bid and ask prices for a certain securities.

Assume Morgan Stanley Capital International (MSCI) wants to buy 1,000 shares of XYZ stock at $10 per share and Merrill Lynch wants to sell 1,500 shares for $10.25 per share. The spread is the difference, or 25 cents, between the asking price of $10.25 and the bid price of $10.

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Individual investors looking at this spread would know that if they wanted to sell 1,000 shares, they could do so for $10 if they sold to MSCI. In contrast, the same investor would be aware that they could buy 1,500 shares from Merrill Lynch for $10.25.

Supply and demand affect the magnitude of the spread and the stock price. More bids will arise from more individual investors or organizations wanting to purchase, while more sellers will result in more offers or requests.

How the Spread Is Matched

A computer may match a buyer and seller on the New York Stock Exchange (NYSE). In other cases, however, a professional who deals with the stock in issue will connect buyers and sellers on the trading floor. In the absence of buyers and sellers, this individual will post bids or offers for the stock to keep the market orderly.

A market maker on the Nasdaq will employ a computer system to post bids and offers, basically serving the same function as a specialist. There is, however, no real floor. All orders are electronically tagged.

Since the implementation of “decimalization” in 2001, spreads on US equities have reduced. Prior to this, most equities in the United States were priced in fractions of a dollar, or 6.25 cents.

Obligations for Placed Orders

When a company publishes a high bid or ask and is struck with an order, it must honor its posting. In other words, in the above example, if MSCI puts the highest offer for 1,000 shares of stock and a seller submits an order to sell 1,000 shares to the firm, MSCI is obligated to fulfill its bid. The same may be said about ask pricing.

In summary, the bid-ask spread always works against the ordinary investor, whether they are buying or selling. The price difference, or spread, between the bid and ask prices is defined by the total supply and demand for the investment asset, which influences its trading liquidity.

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In terms of the bid-ask spread, the major factor for an investor contemplating a stock purchase is simply how confident they are that the company’s price will climb to a point where it will have greatly surmounted the impediment to profit that the bid-ask spread creates. Consider the case of a stock with a bid price of $7 and an ask price of $9.

If the investor buys the stock, it must rise to $10 per share in order for the investor to make $1 per share. However, if the investor believes that the stock is likely to rise to a price of $25 to $30 per share, they anticipate the shares to generate a very big profit over the $9 per-share offer price that must be paid to purchase the stock.

Types of Orders

A person may place five different sorts of orders with a specialist or market maker:

  1. Market Order – A market order may be completed at the current market price. Using the previous example, if the buyer placed an order to purchase 1,500 shares, the buyer would get 1,500 shares at the asking price of $10.25. If they placed a market order for 2,000 shares, the buyer would get 1,500 at $10.25 and 500 at the next best offer price, which may be higher.
  2. Limit Order – A limit order is placed by a person to sell or purchase a certain quantity of shares at a specific price or better. Using the aforementioned spread as an example, a person may place a limit order to sell 2,000 shares at $10. When such an order is placed, the person will instantly sell 1,000 shares at the current offer price of $10. They may then have to wait until another bidder comes up with a bid of $10 or more to satisfy the remainder of the order. Again, the remaining stock will not be sold until the shares trade at $10 or above. If the stock remains below $10 a share, the seller may never be able to sell it. The crucial aspect for a limit order user to remember is that if they are attempting to purchase, the asking price, not only the bid price, must fall to or below the level of their limit order price for the order to be filled.
  3. A day order is only valid for that trading day. The order is canceled if it is not filled that day.
  4. Fill or Kill (FOK) – An FOK order must be completed quickly and in its full or not at all. For example, if a person were to put in a FOK order to sell 2,000 shares at $10, a buyer would take in all 2,000 shares at that price instantly or deny the order, in which case it would be canceled.
  5. Stop Order – A stop order is activated when the stock price reaches a specific threshold. Assume an investor wishes to sell 1,000 shares of XYZ stock if it falls below $9. In this example, the investor might set a stop order at $9 so that the order becomes effective as a market order if the stock trades to that level. To be clear, this does not guarantee that the order will be executed at the precise price of $9, but it does ensure that the stock will be sold. If there are many of sellers, the price at which the order is completed might be significantly lower than $9.
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The Bottom Line

The bid-ask spread is basically an ongoing dialogue. To be successful, traders must be ready to take a stance and exit the bid-ask process using limit orders. Traders that execute a market order without regard for the bid-ask spread or without insisting on a limit are basically confirming another trader’s bid, resulting in a profit for that trader.

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