Understanding Bid and Ask Prices in Trading
The bid/ask spread: What it is and how to use it
When it comes to actually buying and selling shares of stock, the exchanges act more like flea markets than centers of financial sophistication. The scene can be chaotic and it's definitely fast-paced.
You'll need a firm understanding of what's going on if you're going to excel at trading, and that means you must understand the bid and ask prices—what they mean and how to use them.
Differing Stock Prices
Unlike with most things that consumers purchase, stock prices are set by both the buyer and the seller.
The buyer states how much he's willing to pay for the stock, which represents the bid price. The seller also names his price, known as the ask price.
It's the role of the stock exchanges and the whole broker/specialist system to facilitate the coordination of the bid and ask prices. This service doesn’t come without its own price, however.
The Bid/Ask Pricing
You can see the bid and ask prices if you have access to the proper online pricing systems. The Nasdaq structures its pricing around the bid/ask.
You'll notice that the bid price and the ask price are never the same. The ask price is always a little higher than the bid price. What this means is you'll pay the ask price, which is the higher price, if you're buying the stock, and you'll receive the bid price, the lower price, if you are selling the stock.
Understanding the Spread
What happens to the difference between the two prices? This difference is called the spread and it's kept as profit by the broker/specialist who is handling the transaction.
In actuality, the spread goes to pay a number of fees in addition to the broker’s commission. Keep in mind that the broker's commission is not the same commission you'd pay to a retail broker.
Certain large firms, called market makers, can set a bid/ask spread by offering to both buy and sell a given stock.
For example, the market maker would quote a bid/ask spread for the stock as $20.40/$20.45, where $20.40 represents the price at which the market maker would buy the stock. The $20.45 price shows the price at which the market maker would sell the stock. The difference, or spread, benefits the market maker because it represents profit to the firm.
Because prices move constantly, especially for actively traded stocks, you can’t know what price you'll get if you're a buyer or a seller unless you use specific market orders when trading to lock in a certain price.
There are ways around the bid/ask spread, but most investors are better off sticking with this established system that works well, even if it does take a little ding out of your profit. Advanced strategies are for seasoned, expert traders.
This isn't to say that you won't ever get to the point of using them and maybe even excelling with them, but you're probably better off sticking to basic rules when you're starting out and just getting your feet wet. Understanding is key and when you have that down and have witnessed how the market works time and again, you might consider branching out and experimenting on paper with other strategies before you jump in with both feet and a whole fistful of dollars.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.