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Bid, Ask and Stock Orders
There are many kinds of stock market orders. The most simple is the market order in which the stock is bought or sold at whatever price is necessary for the order to execute. In absence of any changes or new orders, a market order is executed at the bid for a sell order or it is executed at the ask for a buy order.
A limit order can help demonstrate where the bid and ask come from.
Let's assume that XYZ Stock last traded at $50 per share and that the bid is currently $49 per share while the ask is $51 per share. If a trader is willing to sell their XYZ stock, but not for less than $50 per share, they cannot use a market order because the bid is only $49. However, they could use a sell limit order.
Issuing a limit order to sell with a limit price of $50 per share means two things, depending on your point of view. From the investor's point of view, the order means that they will sell their XYZ shares at $50 or higher. That is likely all the investor cares about.
But, from a different angle, the quote system now relects that there is someone willing to sell XYZ shares at $50 per share, where no one was willing to sell below $51 per share earlier. Thus, the ask for XYZ has moved from $51 per share to $50 per share. In other words, the investor's limit order has just become the new ask.
The same works in reverse for a buy limit order and it is also one of the places the bid and ask come from.
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The other place a bid or ask can come from are the market makers.
In order to provide continuous liquidity there are market makers for each security. In our example, the market maker ensures that at all times there is a bid and an ask for XYZ stock no matter how many or few people are buying or selling. This is not a pro bono job, the market maker pockets the spread (though in reality this isn't as easy as it sounds).
In the example above, the bid is $49 and the ask is $51 until the investor enters the limit order at $50. But, what if a large seller begins unloading XYZ stock?
Let's say that for the current bid of $49 the buyer is willing to take 500 shares. So, the seller gets $49 per share for the first 500 shares, but if they want to sell more shares then what happens?
If there is another bid, then some shares could be sold at that price. But, what if there are not enough bids to cover the whole amount of shares to be sold? This is where the market maker comes in. The maker might set the bid at $48 for 1,000 shares. If more shares are still coming, the maker can continue to adjust the bids, usually at lower and lower prices until all of the shares are gone.
If, once the larger order is cleared out, the stock works its way back to the previous price, then the maker profits by selling the shares back into the market via the ask. If this is the start of a downward trend for the stock, then the market maker loses money on the shares purchased for higher amounts. Of course, the maker can now profit on the spread at the new level to make up any losses.
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Make Money Trading By Understanding Bid and Ask
Where the bid and ask come from are important to understand so that one can make profitable trades by monitoring things like the spread, large orders entering the system, and even taking note of the direction pointed by increasing or decreasing bids and asks.