The stock market functions like an auction where investors—whether individuals, corporations, or governments—buy and trade securities.
It's important to know the different options you have for buying and selling, which involves understanding bid and ask prices. Unlike most things that consumers purchase, stock prices are set by both the buyer and the seller.
How Does the Bid-Ask System Work?
The buyer states how much they're willing to pay for the stock, which represents the bid price. The seller names their price, or 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 comes with its own expense, which affects the stock's price.
Once you place an order to buy or sell a stock, it gets processed based on a set of rules that determine which trades get executed first.
If your main concern is buying or selling the stock as soon as possible, you can place a market order, which means you'll take whatever price the market hands you at the time.
You can see the bid and ask prices for a stock if you have access to the proper online pricing systems. You'll notice that they are never the same. The ask price is always a little higher than the bid price.
You'll pay the ask price if you're buying the stock, and you'll receive the bid price if you are selling the stock. The difference between the bid and ask price is called the "spread." It's kept as a profit by the broker or specialist who is handling the transaction.
The broker's commission is not the same commission you'd pay to a retail broker.
In actuality, the bid-ask spread amount goes to pay several fees in addition to the broker's commission.
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 might quote a bid-ask spread for a stock as $20.40/$20.45, where $20.40 represents the price where the market maker would buy the stock, and $20.45 is the price where the market maker would sell the stock.
The difference, or spread, benefits the market maker, because it represents profit to the firm. Because prices constantly move, especially for actively traded stocks, you can't know what price you'll get in a trade if you're a buyer or a seller unless you use specific market orders when trading the stock to lock in a certain price.
If you want your order placed almost instantly, you can choose to place a market order, which goes to the top of the list of pending trades. The downside is that you'll receive either the lowest or highest possible price available on the market.
Market orders are best used in situations where you need to buy or sell an investment immediately, and your concern is timing and not price differences.
If you submit a market sell order, you'll receive the lowest buying price, and if you submit a market buy order, you'll receive the highest selling price. In general, market orders should be avoided when possible.
The Bottom Line
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 their profit. If you consider branching out, experiment with a paper-trading account before using real money.
Advanced strategies are for seasoned investors, and beginners may find themselves in a worse position than they began. 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.
Frequently Asked Questions (FAQs)
What are bid sizes and ask sizes?
The bid and ask sizes tell you the number of shares that are ready to trade at the given price. The number represents round lots of shares. These lots are usually 100, so an ask size of 25 would mean that there are 2,500 shares ready to trade at the asking price, but check with your broker to verify the lot size they use.
What does a large bid-ask spread mean?
The wider the bid-ask spread, the more volatile and less liquid that security is likely to be. Trades may not execute as often when there's a large spread, and when they do, the price is more likely to jump around quickly compared to more stable stocks that only move a few pennies at a time. That makes it difficult to predict what price you'll get with a market order, and stop orders are less likely to get the exact stop price you set.