The bid price and the ask price are two of the most foundational elements you need to learn and understand if you want to get into investing. No matter what type of security you are buying and selling, it is critical that you understand this concept. So, what is the difference between bid price and ask price?
In investing, the bid price is the maximum amount of money someone is willing to pay for a particular security. Whereas, the ask price is the minimum amount of money for which the owner of a security is willing to sell.
For example, if you wanted to purchase 100 shares of stock in a particular company for no more than $1,000, you would set your bid price (the maximum you are willing to pay for each share) at $10. However, in order to make the purchase, somebody would have to set their ask price (the minimum they are willing to sell it for) at $10 per share. Only then could the transaction take place.
The entire world of investing centers around this concept. So, for the rest of this post, we are going to explore it further.
Let’s dive in!
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The Bid-Ask Spread
The Bid-Ask Spread is just the difference between the bid price and the ask price for a particular security. For example, if the bid-ask spread for a share of stock is $15/$15.05, then the spread is $.05. In other words, buyers are willing to pay $15, while Sellers are willing to accept $15.05.
Additionally, when somebody is willing to pay the ask price, despite the bid-ask spread, in order to purchase a security, this is known as ‘crossing the spread’.
Market Price And Market Orders
No matter what side of the transaction you are on — either buyer or seller — the bid price and the ask price are what set the market value.
For instance, let’s say you owned 100 shares of stock and you wanted to sell them at market value. The market value would be set at the bid price in the bid-ask spread. So, if the bid price was set at $9, you would end up selling your shares for a total of $900.
Meanwhile, if you set a market order to buy 100 shares of stock in a company, you would pay the ask price in the bid-ask spread. So, if the ask price was $10, your market order would end up costing $1,000.
So you see, the market price is just the value placed on a security by the opposing sides of any trade.
The Role Of Bid Price and Ask Price In Liquidity
Typically, when there is a big difference between the bid price and the ask price of a security, it means there is not much trading going on. This is not a good thing when you are a seller, because it can leave you stuck with a stock you don’t want to own.
In contrast, the narrower the spread between the bid price and the ask price of a security, the easier it is to sell. This is a very good thing as a seller, because it means there is plenty of trade volume around the ask price. This, in turn, means less risk as an investor.
Think of it like this, as a kid, if you decided to open a lemonade stand in the middle of winter — when the demand for lemonade is low — and sell each cup for $5, if customers were only willing to pay $1, you would be experiencing a bid-ask spread of $4. Now, you could choose to sell your lemonade for a significantly lower price, and cut your losses. Or, you could choose to hold at your price, but you might end up waiting until July before somebody was willing to buy a cup at your ask price. This is an example of low liquidity.
Meanwhile, if you lowered your price to $1.01, because the difference between your ask price and the bid price of your customers was much smaller, you would have a much easier time selling your lemonade. In other words, you would be much more liquid.
The same applies to buying and selling securities. The closer the bid price and the ask price are to one another, the more liquid the security is.
Limit orders are used as a way to buy a security at a set price that is better than the current price. For example, if you decide to set a limit order for 100 shares of stock at $5, while the ask price is $5.05, then the order will not be placed until the price of that stock drops to at least $5.
As a seller, this works in reverse. So, if the current price of a given security is $5.05, and you set a limit order to sell at $5.10, then the order will not be placed to sell until somebody is willing to pay $5.10.
3 Factors That Affect Bid Price And Ask Price
When it comes to the bid-ask spread, there are a number of factors that can affect how wide or narrow it is. In this next section, we will cover three of them.
The larger the market size and trading volume that happens on a daily basis for a particular security, the narrower the bid-ask spread is likely to be. Which makes total sense if you think about it. I mean, if there are 1 million people wanting to buy a particular stock, it is much more likely that you will be able to sell it if you need to liquidate your shares.
On the other hand, if you are trying to sell a particular security, but there are only 100 people interested in buying it, you are much less likely to sell for a high price.
In short, volatility widens the bid-ask spread. Why? Because if the price of a security jumps and falls wildy, or without any predictability, market-makers have a much harder time setting the ask price or the bid price. Remember, unpredictability is the opposite of liquidity. This lack of liquidity is reflected in the bid-ask spread.
When people are uncertain about the political or economic climate, people tend to play it safe with their investments. In other words, sellers stop selling, and buyers stop buying. Or at least, sellers stop dropping their ask price, and buyers stop increasing their bid price.
Uncertainty, like volatility, causes the bid-ask spread to widen.
Bid price and ask price are two of the most foundational elements you need to understand as an investor. Not only that, you need to firmly grasp the meaning of the bid-ask spread, and what factors can affect it.
The world of investing can be complex at times. But, when it comes down to it, it’s really just centered around the concept of bid price and ask price.