The stock market works similarly to an auction where individuals, governments, corporations, and other types of investors trade and buy securities. Investing in stock has been proven to be one of the best ways to generate wealth, especially long-term. When investing, it is crucial to know the various options for buying and selling at your disposal. That includes understanding the bid and ask prices.
Unlike most items purchased by consumers, the price of a stock is determined by the seller and buyer. Also known as bid and offer, the term bid and ask is defined as a two-way price quotation signifying the best possible price at which a particular security can be bought and sold at a given time. To have the highest advantage when trading securities, understanding ask and bid should be your priority.
Definitions
The bid price
This refers to the price an investor is willing to pay for a particular security. For instance, if you want to sell a stock, you must establish how much the other party is willing to pay, which is done by checking the bid price. It is the highest price an investor is willing to pay for your stock.
The ask price
This is the price an investor is ready to sell their security for. Say you want to purchase a stock, you must first find out how much the other party is prepared to sell it for.
Note: The difference between ask and bid prices or spread is an essential indicator of an asset’s liquidity. Generally, a smaller spread is a sign of better liquidity.
How the ask and bid system functions
In this system, the buyer first states how much they are ready to pay for a stock which signifies the bid price. The seller then states their cost, the asking price. The stock exchange and entire broker-specialist system are tasked with facilitating the synergy of the bid and ask prices. This service has its own separate expense, which also affects the price of a stock.
As soon as you place your order to sell or buy a stock, it is processed based on specific rules that regulate the order in which trades are executed. If you are primarily interested in selling or purchasing the stock swiftly, you can place a market order. By doing so, you’ll have to accept whichever price the market offers at that given point.
Bid and ask pricing
You can see a stock’s bid and ask price if you access the correct online pricing systems. Once you do, you’ll quickly notice that they are never identical. Typically, the bid price is always slightly lower than the ask price. If you purchase the stock, you’ll have to pay the ask price, and if you sell it, you’ll get the bid price.
The result is a ‘spread,’ which is the difference between the ask and the bid price. It is retained by the specialist or broker handling your transaction as profit. The commission you’d pay a retail broker is not that of a broker. In addition to the commission, the spread amount is used to pay several broker’s fees.
Some large corporations called “market makers” sometimes set a spread by volunteering to sell or buy a stock. The spread (difference) benefits such a corporation since it generates a profit. Since prices are constantly shifting, especially in the case of actively traded stock, it is difficult to predict the price you’ll receive in a trade as a buyer or seller.
It is only possible if you use specific market orders to lock in a particular point during the trading process. The bid-ask spread is crucial if you want to buy a security at the best price.
Examples of bid-ask spreads
Most traders usually don’t see a significant impact on the spreads if they tend to trade in highly-liquid, high-profile stocks. The reason is that such spreads are generally tighter, so sellers and buyers aren’t significantly impacted. Bid and ask spreads can arise from:
1. Highly liquid stocks: These are huge highly-traded capitalization stocks.
2. Low liquidity stocks: These are stocks that aren’t traded often.
While it is possible to find low liquidity stocks throughout financial markets, they are primarily found in the small-cap section or lightly-traded ETFs (exchange-traded funds). The market maker or broker makes their profit on a particular trade through the spread. They charge you this price for matching you with a seller or buyer quickly and efficiently.
When funds and stocks aren’t trading frequently within the market, they work harder to pair sellers and buyers, often with highly volatile securities. The market maker or broker charges the investors a markup for the additional effort and extra price risk.
Take away
You can utilize some strategies to work your way around a spread. However, you are usually better off sticking to the system in place. Even if it takes a small chunk of your profit, it works well.
