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We have seen how the bid and ask work to determine a stock's price and how the bid and ask are what cause a stock price to change. Now, we look closer at how the bid and ask create profitable trades and help create liquidity.
In order for the stock markets to opperate efficiently, they need to be liquid. That is, a buyer needs to be able to buy stock when they want, and a seller needs to be able to sell stock when they want.
The opposite of this style of buying and selling can be demonstrated by the real estate markets. Just because you want to buy a house, doesn't mean anyone will sell it to you. Just because you want to sell a house doesn't mean anyone will buy it. As many homeowners saw during the tough real estate market in 2008, putting a house up for sale is no guarantee that the house will sell at any price.
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How The Bid/Ask Spread Works
The spread between the bid and the ask for a stock keeps the stock markets liquid.
If XYZ stock recently traded at $50 per share and now has a bid of $49 per share and an ask of $51 per share, there would be no trades until something changed.
Suppose someone wanted to buy 10,000 shares of XYZ stock. The ask of $51 might only be good for 200 shares. Then the next ask of $51.50 might be good for 200 shares. Maybe the next ask is at $53 per share. At this point, the spread would be $4 per share -- from $49 bid to $53 ask.
If the order to buy had been a market order for the whole amount (not rare, but not likely either) then the shares would continue to be bought as the prices when up. Completing the full 10,000 share buy order could theoretically occur as 200 @ $51, 200 @ $51.50, 500 @ $53, and 200 @ $53.50. The last trade and thus the current quote showing on the ticker would be $53.50. But, the bid would still be $49, if nothing changed, while the ask might still be $53.50.
In this example, the stock could trade at $53.50 one second, and then at $49 the next (a market order sell), and then at $53.50 the next second (a market order to buy). While this can and does happen it doesn't make for a very orderly market.
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Breaking Down the Spread
What actually happens is that traders all over the world (and more realistically, their computers) monitor the bid and ask on a stock. As the price of XYZ stock moves higher, it makes more sense for someone to be willing to pay more to buy the stock and it also makes it more attractive to sell the stock.
In our example above, when the buy order started, there was an investor willing to buy at $49 (the bid) which was $1 less than the last trade and $2 less than the ask. There are two possibilities. It may be that the trader in question thinks that XYZ is currently worth $49 per share and no more. In this case, they are not likely to raise their bid. Alternatively, it could be that the trader thinks that he can make a profitable trade by buying a $1 per share below the last trade. In this case, they may raise their bid as the stock trades higher. Either way, it is also possible that a trader who up until now did not have an active interest in XYZ may now be interested and put in a bid/ask of their own.
Let's take just one scenario to see how the bid and ask makes the market more orderly.
When XYZ trades 200 shares at $51, the LAST becomes $51. A trader sees that XYZ has traded at $51 per share. He also notices that there is an ask for 200 shares at $51.50 and that the next ask is at $53.50 with 600 shares of the buy order remaining. The trader could insert an ask for 600 shares at $52 per share followed by putting in a bid at $50 per share for 600 shares. In real life, this often involves computers.)
If this were all to occur without any other changes (again, only for example purposes) then the trader would be able to sell 600 shares at $52 per share and then buy 600 shares (to net out at zero) for $50 per share resulting in a profit of $2 per share. This is referred to as arbitrauge.
In this case, the original buyer gets a better price for his shares because of the lower asking price and the other trader also makes a profit. It is a win-win for everyone and the market is that much more orderly as the price moves from $50 to $51 to $51.50 to $52 and then to $49.50.
Of course, there could be more (many more) traders than just the one in this example trying to do the same thing, thus, someone might step in with a similar strategy at $51.75 ask and $49.75 bid or $51.60 ask and $50 bid and so on.