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The terms spread or bid-ask spread are essential for stock market investors. The bid-ask spread can affect the price at which a purchase or sale is made and thus an investor’s overall portfolio return.
Key Takeaways
- The bid-ask spread is largely dependent on liquidity. The more liquid a stock is, the tighter the spread.
- The buyer or seller must purchase or sell their shares at the agreed-upon price when an order is placed.
- Different types of orders trigger different order placements.
- Some order types such as fill-or-kills won’t be filled by the broker if the exact order isn’t available.
Supply and Demand
Investors must first understand the concept of supply and demand before learning the ins and outs of the spread. Supply refers to the volume or abundance of a particular item in the marketplace, such as the supply of stock for sale. Demand refers to an individual’s willingness to pay a particular price for an item or stock.
The bid-ask spread is therefore a signal of the levels where buyers will buy and sellers will sell. A tight bid-ask spread can indicate an actively traded security with good liquidity. A wide bid-ask spread may indicate just the opposite.
The bid-ask spread will expand substantially if there’s a significant supply or demand imbalance and lower liquidity. Popular securities like Apple, Netflix, or Google stocks will therefore have lower spreads. A stock that’s not readily traded may have a wider spread.
An Example of the Bid-Ask Spread
The spread is the difference between the bid price and the ask price for a particular security.
Assume Morgan Stanley Capital International (MSCI) wants to purchase 1,000 shares of XYZ stock at $10 and Merrill Lynch wants to sell 1,500 shares at $10.25. The spread is the difference between the asking price of $10.25 and the bid price of $10 or 25 cents.
An individual investor looking at this spread would then know that they could sell 1,000 shares at $10 by selling to MSCI. The same investor would know that they could purchase 1,500 shares from Merrill Lynch at $10.25.
The size of the spread and price of the stock are determined by supply and demand. The more individual investors or companies that want to buy, the more bids there will be. More sellers would result in more offers or asks.
How the Spread Is Matched
A buyer and seller may be matched by computer on the New York Stock Exchange (NYSE) but a specialist who handles the stock in question will match buyers and sellers on the exchange floor in some cases. This individual will also post bids or offers for the stock in the absence of buyers and sellers to maintain an orderly market
A market maker on the Nasdaq will use a computer system to post bids and offers, essentially playing the same role as a specialist. There’s no physical floor, however. All orders are marked electronically.
Spreads on U.S. stocks have narrowed since the advent of “decimalization” in 2001. Most U.S. stocks were quoted in fractions of 1/16th of a dollar or 6.25 cents before this.
Obligations for Placed Orders
A firm must abide by its posting when it posts a top bid or ask and is hit by an order. MSCI must honor its bid if it posts the highest bid for 1,000 shares of stock and a seller places an order to sell 1,000 shares to the company. The same is true for ask prices.
The bid-ask spread is always to the disadvantage of the retail investor regardless of whether they’re buying or selling. The price differential or spread between the bid and ask prices is determined by the overall supply and demand for the investment asset and this affects the asset’s trading liquidity.
The primary consideration for an investor who’s considering a stock purchase is the question of how confident they are that the stock’s price will advance to a point where it will have significantly overcome the obstacle to profit that the bid-ask spread presents.
Consider a stock that’s trading with a bid price of $7 and an ask price of $9. The investor would have to advance to $10 a share simply to produce a $1 per-share profit. They expect that the stock will show a very significant profit beyond the $9 per-share ask price that must be paid to acquire it, however, if the investor considers that the stock is likely to advance to a price of $25 to $30 a share.
Types of Orders
An individual can place five types of orders with a specialist or market maker.
Market Order
A market order can be filled at the market or prevailing price. The buyer would receive 1,500 shares at the asking price of $10.25 if the buyer were to place an order to buy 1,500 shares. The buyer would get 1,500 shares at $10.25 and 500 shares at the next best offer price which might be higher than $10.25 if they placed a market order for 2,000 shares.
Limit Order
An individual places a limit order to sell or buy a certain amount of stock at a given price or better. They might place a limit order to sell 2,000 shares at $10. The individual would immediately sell 1,000 shares at the existing offer of $10 when placing such an order. They might then have to wait until another buyer comes along and bids $10 or better to fill the balance of the order.
Again, the balance of the stock won’t be sold unless the shares trade at $10 or higher. The seller might never be able to unload the stock if it stays below $10 a share. The key point an investor must keep in mind when using limit orders and trying to buy is that the asking price and not merely the bid price must fall to the level of their limit order price or below for the order to be filled.
Day Order
A day order is good for only that trading day. The order is canceled if it’s not filled during that time.
Fill-or-Kill Order
A fill-or-kill (FOK) order must be filled immediately and in its entirety or not at all. A buyer would take in all 2,000 shares at that price immediately or refuse the order if someone were to put in an FOK order to sell 2,000 shares at $10, in which case it would be canceled.
Stop Order
A stop order goes to work when the stock passes a certain level. Suppose an investor wants to sell 1,000 shares of XYZ stock if it trades down to $9. The investor might place a stop order at $9 in this case so the order becomes effective as a market order when the stock does trade to that level.
This doesn’t guarantee that the order will be executed at exactly $9 but it does guarantee that the stock will be sold. The price at which the order is executed might be much lower than $9, however, if sellers are abundant.
What Does It Mean If a Stock Is Liquid?
A liquid stock can easily be sold and converted into cash without losing any value. Liquidity can also describe the overall stock market in terms of investor risk.
What Is a Day Trader?
A day trader opens and closes all their positions before the trading day closes. They don’t hold trades overnight. They work in tandem with day orders by definition.
What Is the Role of the New York Stock Exchange?
The New York Stock Exchange (NYSE) was created in 1817 as the New York Stock and Exchange Board. It was renamed as simply the New York Stock Exchange in 1863. As the name implies, the NYSE exists to facilitate and regulate trades of securities as well as the corporations listed on it.
The Bottom Line
The bid-ask spread is essentially a negotiation in progress. Traders must be willing to take a stand and walk away in the bid-ask process through limit orders if they want to be successful. Traders are essentially confirming another trader’s bid and creating a return for that trader by executing a market order without concern for the bid-ask and without insisting on a limit.