The stock market operates more or less like an auction. Buyers forward bids for a certain number of shares at a certain unit price while sellers offer a certain number of shares at a certain unit price. These are known as ‘bid price’ and ‘ask price’. This article explains the two concepts in a bit more detail.
In an auction, sellers offer goods and services to willing buyers. The willing buyer, willing seller principle demands that the highest bidder gets to own whatever is on sale. To acquire the product or service, she will have to bid competitively, which means paying the most competitive price. With this considered, the bid price is the buy order whose price is the highest in the market currently.
The bid price is the highest price the buyer is willing to pay to acquire stock. This implies that the buyer has a significant say in the prevailing market price for stocks. Given the competitiveness witnessed in the stock market, the bid price can change in seconds. Stock exchanges usually quote the bid price and the number of shares included in the buy offer. For the buyer to receive the desired stock, a seller in the stock market must accept the buy order at the quoted price. Given that, there is no guarantee that a bid price will be acceptable.
The ask price is on the opposite side of the bid price. Otherwise called the offer price, this is the lowest bid a seller is willing to accept to offer the stock to a buyer. Usually, the value of the ask price is higher than the prevailing market price of the stock. Buyers use the ask price to determine the size of the bid price they attach to the buy order.
Most exchanges quote the highest bid price and the lowest ask price, and there is always a difference between the two sets of prices. Traders call the difference the bid-ask spread. A transaction between the buyer and the seller is likely to happen only when there is no spread; that is, the ask price matches the bid price.
Bid-ask spread explained
From an economic point of view, forces of demand and supply within the stock market determine the bid and ask price. The bid-ask spread is the difference between the bid price and ask price.
The bid-ask spread is an important measure of market liquidity. A small spread implies that the market is liquid, while large spreads imply an illiquid market. The spread plays a major role in determining how investors set up their trades and their portfolio.
In some markets, this spread will make up the bulk of the profits that brokers earn. Given the high liquidity of some stocks, some traders might want to lock in a given price for a stock. Locking in the price means that the trader will also determine the bid-ask spread. This move is mostly available to market makers.
For instance, a market maker interested in IBM’s shares might want to buy the shares at 93.23 and sell at 93.28. Here, the bid price is 93.23, and the ask price is 93.28. The bid-ask spread is the difference between the two prices, which is 0.05. If the market maker succeeds in the trade, the spread represents the profit margin. Using such market orders is the best way to lock in profits, especially when the stock is liquid. Market orders help traders to beat the market’s volatility.
With a market order, a trader can rest easy knowing that the market will execute the order. Nevertheless, the fast-changing nature of the prices in the market makes it difficult to guarantee order execution at the set price. Buy orders usually execute closer to the ask price while sell orders execute closer to the bid price.