How do bid-ask prices work in stock trading?

Understanding how bid-ask prices work in stock trading is important if you’re getting into investing. Let’s start with a straightforward definition …

Bid price (or just plain “bid”) refers to the maximum price that buyers are willing to pay for a security. Conversely, ask price (“ask”) is the minimum price that sellers want to receive for a security.

So if you sell a stock, you’ll get the bid price, and if you buy, you’ll get the ask price. Keep in mind that the ask price is always higher than the bid price … after all, no one wants to lose money doing business.

Just like an auction, transactions are made when a seller’s ask price matches a buyer’s bid price. These prices are constantly changing, so the bid is simply the highest quoted price at that very moment, and the ask is the lowest.

Spread

The spread is the difference between the bid and ask prices. So, if a buyer wants to purchase 500 shares of Poppins Purses stock at $20, and a seller is looking to sell 1,000 shares at $20.05. The bid-ask spread would be 5 cents.

Three cheers for simple arithmetic!

In general, the smaller the spread, the more liquid (actively traded) the security. Typically, the spread is only a few pennies, although it tends to rise during times of market trouble because traders don’t want to pay above a certain level, and sellers don’t want to accept low prices.

Risk compensation

So what happens to the difference between the bid and ask prices? The market maker (the individual or firm that quotes the bid and ask prices for a given security) pockets it for profit. The NASDAQ is one operation of market makers— there are more than 500 member companies that trade securities through an electronic network. These companies receive payment as a compensation for risk.

What’s the risk? Let’s explain…

In a normal, liquid market, there are usually plenty of people willing to buy when you want to sell and sell when you want to buy. But sometimes, it doesn’t work out that way. In such cases, a market maker must make bids and offers from its own account in order to make sure that market transactions keep running smoothly. Obviously, this is a risky move for the market maker, as it could lose money if the stock sells for lower than purchase price.

Bid-ask size

But what about the bid-ask “size” that you sometimes see in quotes for stocks trading on exchanges like the NYSE and ASE? Here’s the breakdown…

The NYSE and other listed exchanges (ASE, Midwest, Boston, Pacific, etc.) use “specialists” to match up the orders for a particular stock. The size of the bid-ask shows how many shares the specialists have available at those prices. For example, if an investor wanted to buy 100 shares of Poppins Purses, the bid size would be 100 shares. (Note: stock exchanges quote bid-ask sizes in the hundreds, so in this example, the bid size quote would show up as 1, not 100.)

In general, a larger ask size than bid size means that at that moment, there are more sellers than buyers and thus a downward pressure on the stock’s price.

What does the spread and bid-ask size mean for you?

Now that you’ve got the basics down, let’s talk about how spreads and bid-ask sizes might affect your decision of whether or not to trade a security.

Well, it turns out that you shouldn’t be paying much attention to these numbers unless you’re a market maker or a sophisticated trader. Spreads and bid-ask sizes can change in an instant, so you shouldn’t give them much thought — especially if you’re on the NASDAQ, where all orders are marked electronically.

However, when you start dealing with less liquid (thinly traded) securities, it’s important to pay more attention to these figures. As we mentioned above, lower liquidity means larger bid-ask spread. So if you submit a market order to buy your stock, you might end up paying more than you’re comfortable with.

This is why we Fools generally recommend limit orders, which allow you to buy or sell a stock with a specific price target in mind. With limit orders, you won’t end up paying more or selling for less than you’re willing to.

If you want to see what some of our Fools have to say about limit and market orders, check out the articles written by two of our most Foolish specialists, Tim Beyers and Selena Maranjian. And if you’re looking for more information on bid and ask prices, get the run-down from Jason Moser, one of our masterly Motley Fool One analysts.

— Answer provided by Motley Fool intern Caroline Jennings

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