The bid price, more usually referred to as the ‘bid,’ is defined as the highest price at which a buyer is willing to purchase a financial instrument such as a stock or an ETF. It entails both the quantity required and the price the investor is willing to pay.
The ask price, typically referred to as the ‘ask’, is defined as the minimum amount that a seller is ready to take for the financial instrument.
More on bid and ask
Suppose you went to an art gallery and you find a really cool painting for your wall. The artist who painted it would first need to know how much someone was prepared to pay for it. He would do this by simply examining the bid price. The bid price reflects the amount above which the buyer is not willing to pay. In other words, the maximum price a buyer is prepared to pay for the stock.
Now, there you are – the buyer! You need to buy the painting, but you would need to first find out how much someone else is ready to sell it for. This will give an idea of its current market value. So, you would examine the ask price, which is the amount below which the seller would not accept. In other words, it serves as an indicator of the stock’s value.
Many retail investors fail to grasp the importance of the bidding and asking price concepts in transactions. In order to understand the current stock price, one must keep in mind that it is based on the price of the most recent deal. As a result of this, the bid and ask are the prices at which buyers and sellers are ready to engage in negotiations. We can say that the demand for the security is the bid, while the supply of the security is the asking price.
Trace Sparks is a fictional company looking to sell the shares of its stock, so let’s look at its bid/ask price.
- The Bid price is $14: this price is the highest bid for the shares. Keep in mind that other bidders are bidding at a lesser price as well. If you wanted to sell your stock at the current market price, you would most likely get $14 for your shares.
- The Ask price is $14.25: The ask price is essentially the minimum price the seller would agree to trade his shares. This makes other sellers offer a higher price. So, if you want to purchase shares, $14.25 is the price you will pay.
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.
What is bid and ask size?
In every market, transactions are not done readily as buyers and sellers are reluctant to accept the same price and thus ensues a lot of bargaining. That’s when the differences between the bid and ask sizes come into play.
If an investor is looking at level 1 data on their trading screen, the bid and ask prices are likely to have an additional number next to them in brackets. These indicate the amount of shares that investors are ready to trade at the current bid/ask price. You would find these bid/ask sizes in board lots of 100 shares. Therefore, a bid size of 10 represents 1000 shares. If the lot size can be divided by 100, it is referred to as a round lot, while those that can’t are called odd lots – for example 80.
Typically, lower-priced stocks are quoted in lots of 100, while the higher-priced ones are quoted in 10 or fewer lots.
Using the Trace Sparks example again, their bid price can be stated as “$20 (10)”. This indicates that there are 1,000 pending transactions of shares at a $20 bid price. If you decide to sell 100 shares, you would receive $20, but if you wanted to sell say, 1,575 shares, then you would sell some of your order at $20. You may then trade the others at a different price – depending on the type of your order.
There is not much difference with the ask price. A $25 (20) ask price would indicate that there are 2,000 pending $25 transactions. To get 100 shares, you would likely have to spend $25.
A large bid size often translates to significant demand for a stock. This is because it generally equates to a large supply.
Stock prices are more likely to increase if the bid size for the stock exceeds the ask size, and it is a sign that demand is greater than supply. In contrast, if the ask size is more than the big size, it implies that the stock is oversupplied. And in that situation, the price is likely to drop.
What does a large bid-ask spread mean?
The difference between what someone is willing to pay and what they are willing to accept is known as the bid-ask spread. When a seller is willing to sell, the ask price is the price/value point at which they are willing to accept a buyer’s offer. A transaction takes place when the buyer and the seller’s respective price points align, i.e. when they agree on the prices being provided by each other.
Demand and supply are the key market forces that set these prices, and the difference between them is what determines the spread between the purchase and sell prices. We’re talking about a widening disparity! It is possible to express the bid-ask Spread in absolute and percentage terms. Spread values may be minimal in a highly liquid market, but they can also be quite huge in an illiquid or in a less liquid market.
The bid-ask spread affects the volatility and liquidity of a stock or an ETF. The wider it is, the more volatile and less liquid the stock or ETF will be. When there is a large spread there are not many trades that will be executed. When they do, the prices change more rapidly than what is obtained in stable stocks that change by just a few pennies per time. The effect of this is the reduced predictability of the prices in a market order and the reduced probability of trading at the exact stop price that you set.
Calculating the spread
Bid – Ask Spread (absolute) = Ask/Offer Price – Bid/Buy
Price Bid-Ask Spread (%) = ((Ask/Offer Price- Bid/Buy Price) – Ask/Offer Price) * 100
Let’s take a stock with a bid price of $19.95 and an offer price of $20. Here, the bid-ask spread is 5 cents. The spread expressed in percentage is $0.05 / $20 or 0.25 percent.
You would lose 0.25 percent of the transaction value if you purchase the stock for $20 and then immediately sell it for $19.95, either by mistake or on purpose. If you decide to buy and immediately sell 100 shares, you would lose $5, while if you had purchased 10,000 shares the loss would be $500. In both instances, the spread results in the same percentage loss.
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