Using Bid And Ask In Stock Trading

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The mechanics of buying and selling

In all publicly traded goods or assets, the purpose of the open market(s) is to match a buyer to a seller and vice versa. In a grocery store or a supermarket, the seller indicates the prices that she is comfortable with and the buyer (consumer) usually has no choice but to accept or walk out of the store and search elsewhere for what her heart desires.

Holding or looking to buy?

In stock trading, one investor maintains a long position on a stock, while others are on the outside looking in. The investor with the long position usually is willing to part with his holdings at a certain price or price range, but not at other(s). She may want to optimally sell Citibank at $10, but definitely not sell at $8. The shrewd broker might break down the order to sell 10,000 Citibank shares at various price levels, and enter the following limit sell orders in the system: Sell 2,000 at 8.50; 2,000 at 9; 2,000 at 9.50 and 4,00 at 10, and see how things go. If the market is weak, a large sell order at $10 might just send prices lower with no execution whatsoever.

For the investor on the outside looking in, things are not that different: she might want to buy at $9, but not $10. On her Level II quotes system, she sees what is offered on ask – that is all the prices quoted above. It’s called, collectively, the ask, because that is what the seller asks to part with his holdings. She can now either buy all shares offered up to $9 (that would be 2,000 at 8.50 and 2,000 at 9), by entering a market buy order at $9 for Citibank, or she can enter her own limit buy order(s) a bit lower, say 6,000 at $7.50 and 4,000 at $8 (which now effectively becomes the bid price) to lure more sellers into her own comfort zone.

The Bid-Ask Spread

On a level I quotes system, the investor sees the best bid and ask price; in our example, that would be (BxA: 8 x 8.50 and the respective volumes: 4,000 x 2,000). The difference between these two (highest price that a buyer is willing to pay and lowest price for which a seller is willing to sell) is called the Bid-Ask spread. If you have access to level II quotes (or any kind of software/platform that gives the market depth of a stock) you get to see more buy/sell orders (usually the 5 best on the bid and the ask side, sometimes more, depending on your platform), which presumably enables one to understand which way the market will go next. If buyers dominate the market, it would be logical to deduce that price is bound to go up and, unfortunately, vice versa.

One school of thought regarding day trading contends that a day trader’s aim is to capture the bid-ask spread. In our example, if the trader manages to, say, buy near the bid and sell near the ask, she would make $0.50 quite effortlessly. If the stock is very liquid, however, the spread is considerably less wide and in some cases it can be just a few cents on a $40 stock, making the transaction unattractive from this point of view. In distressed stocks and illiquid issues, spreads can be wider, sometimes even as wide as 5% or even 10%; but low volume also means that chances are your order will not get filled, as not many orders are actually filled on a daily basis.