What is the Bid-Ask Price Spread and how is it used for trading?

Investing in stocks is a proven way to build wealth, with the Standard & Poor’s 500 generating double-digit returns in eight of the past 10 years.

A key part of stock market investing is trading in stocks and funds, a process often managed by brokers, specialists and market makers, working in tandem with individual exchanges.

When executing stocks and funds trades, investors should understand the concept of supply versus demand, which defines the supply and demand for a specific financial asset.

If you want to trade securities with maximum advantage, controlling supply versus demand should be a priority.

What is the Bid-Ask?

A stock bid-ask, also known as a “spread”, is the difference between a stock’s bid price and its ask price. Individual exchanges like the New York Stock Exchange or NASDAQ work with stock specialists and brokers to define the supply and demand of a security.

The bid-ask spread is also the key to buying a security at the best possible price.

Normally, the asking price is higher than the bid price, and the spread is what the broker or market maker earns by profiting from managing the execution of a stock trade.
Essentially, supply is the price that an investor is willing to pay to buy a particular stock at any given time, and demand is the price at which an investor is willing to sell a stock at any given time.

For example, you might consider a stock in ABC Corporation, which has a bid price of $ 25 and a ask price of $ 26.75 per share. In this scenario, the bid-ask spread is $ 1.75.
The bid-ask spread only impacts individual stocks and not mutual funds that also include stocks. This is because mutual funds only set their prices once a day and investors pay the same price to buy or sell a fund.

Understanding the bid-ask spread when trading stocks is key to getting the best price, whether as a buyer or a seller. This is especially the case with stocks that are not traded as often (i.e. ‘less liquid’ securities), where bid-ask spreads are wider and therefore have more impact on markets. commercial executions.

It’s understandable that investors can scratch their heads over the math behind the bid-ask spread. After all, in a supply-demand scenario, the buyer is asked to pay the higher price (the demand) and the seller is asked to accept the lower price (the offer).

Let’s see how it works in the real world, with the following examples.

Examples of Bid-Ask spreads

The reality is that most investors won’t see much of an impact on bid-ask spreads, especially if they’re trading larger, highly liquid stocks where bid-ask spreads are tighter and both buyers and sellers. sellers are not. impacted by bid-ask spreads.

Very liquid stocks. Consider the bid-ask price on 3M Company
(MMM) – Get the 3M Company Report , a highly traded large cap stock. A current preview (and the bid-ask changes all the time) has the stock’s bid at $ 189.24 and the ask is at $ 189.28 – for a bid-ask spread of four cents.

Low liquidity stocks. Or, consider a stock that doesn’t trade that often – we’ll call it XYZ Corp. This stock, which doesn’t trade often, has a bid of $ 9 per share and a ask of $ 10.50 per share, for a wider spread of $ 1.50.

Usually, while investors can find stocks with low liquidity in all corners of the financial markets, you will find them mostly in the sector of small caps (small caps) or lightly traded exchange-traded funds (ETFs), where stocks don’t trade as often as larger, more liquid stocks like 3M.

Stocks and funds with low liquidity also have wider spreads for a unique reason.

The bid-ask spread is how a broker or market makes a profit on a trade execution – the price charged by the stock specialist to effectively and quickly match buyers and sellers.

When stocks and funds don’t trade as often, the market specialist works to match buyers and sellers, usually with a security that trades with higher volatility. For that extra effort, the broker or market maker charges investors a markup, for the extra work – and extra price risk – they take on.

Six big points to remember about Bid-Ask spreads

Once fully explained, the concept of supply and demand becomes easier for investors to understand and apply the spread in their trading decisions.

In doing so, however, be sure to consider these key points about bid-ask spreads:

    The bid price is the highest price that a buyer of securities will pay.

    The asking price is the lowest price that a securities seller will accept.

    The asking price is often referred to as the “offer price”.

    When a bid price overlaps with a ask price, a trade is usually executed.

    The more liquid a share or fund, the narrower its bid-ask spread. Conversely, the lower the liquidity of a stock or fund, the wider the bid and ask spread. It’s not uncommon for widely traded stocks like Google to have a single penny bid-ask price.

    Supply and demand are perhaps the main driver of supply and demand differentials – besides liquidity. The more a share or a fund is requested, the more its spread is reduced. Highly volatile sticks can also move bid and ask spreads significantly.

    Types of stock / fund work orders

    Investors looking to take advantage of bid-ask spreads can do so with the following types of trade orders, all issued to brokers, specialists or market makers.

    • Market order. This is a trade order to buy or sell a stock or fund on an immediate basis. A specialist will guarantee that the order is executed, but will not guarantee the price at which the trade is executed. In terms of supply and demand, a market order will be executed at or near the standing supply and demand level when buying or selling a stock or fund. Note: Investors should not expect to execute a trade order at the price they see on sites like TheStreet.com. Stock prices change all the time and the last traded price is not always the price at which the trade is executed.
    • Limited order. This type of order allows the buying and selling of a stock or fund at a specific price, or better. There are spreads with limit orders and investors should be aware of them. For example, a buy limit order is only executed at the security’s limit price – or less. Let’s say you place a limit order to buy shares of XYZ Corp. at a price not exceeding $ 20 per share. In this scenario, the order can only be executed if the share price is $ 20 or less.
    • Stop the order. A stop order, or “stop-loss” order, is an order to buy or sell a stock or fund after the security reaches a specific price level. This level, known as the stop price, results in an executable trade once the stop order reaches this level, and is executed as a limit order.
    • Buy a stop order. A buy stop order is a stop price execution order that is priced above the current market price for a stock or fund. A buy stop order is a useful tool to limit a loss on the security that the investor has sold short.
    • Sell ​​stop order. Conversely, a sell stop order is executed at a stop price lower than the current market price for the security. Stop sell orders are often implemented to limit a loss on a security, or to safeguard profits already made on a security.

    The gap between supply and demand is a critical part of trade executions and getting to know supply and demand makes you a better investor and a more savvy trader.

    Find out how bids and requests are applied and how orders from specific traders can be used to get a better execution price.

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