By Charles Qi, CFA
Special to the Financial Independence Hub
Stock market traders use a lot of jargon. Terms like “haircut,” “candlestick,” and “circuit breaker” are commonplace in the trading community, but for the average investor, not so much.
For the most part, knowing the meanings of these terms is not critical. However, there are some terms used by traders that investors should know and understand well because they’re used on a regular basis. So, in this article, I’ll share what I consider to be some of the most important terms to know when it comes to investing: bid, ask, and spread.
Bid: The highest price a buyer will pay for a stock
A trader seeking to purchase a stock or other asset will make their intent known by placing a “bid.” The bid represents the highest price the buyer is willing to pay for the stock. Establishing a bid is not only important for the buyer, but also the seller: the range of bids from interested buyers helps sellers determine how much market interest there is in a particular stock.
Ask: The lowest price a seller will accept for a stock
On the opposite side, an “ask” refers to the lowest price a seller is willing to sell a stock for. The ask represents the supply side for a market for any given stock, while the bids represent demand.
Bid-ask spread: The difference between the ask and bid
Typically, the ask — also known as the “offer price” — will be higher than the bid. The difference between the bid and the ask is known as the “bid-ask spread,” or simply the “spread.” The smaller the spread, the easier it is to buy or sell a stock. That’s because, with smaller spread, less movement is needed to bring buyers and sellers to an agreeable price and conduct a transaction. Generally speaking, stocks and other assets that are being traded in higher volumes tend to have smaller spreads.
That’s because there are more buyers and sellers competing against each other, making the market more efficient. It’s important for investors to understand the bid-ask spread because of its impact on cost: the higher the spread, the higher the transaction cost.
The bid-ask spread and stock market liquidity
Liquidity — how easily a stock can be traded — is important for investors to assess before buying a stock. When the spread is smaller, liquidity is typically higher, and the higher the liquidity, the easier it is to sell. When a buyer pays the asking price for a stock with low liquidity and high spread, they’ll need to see a higher degree of price movement before the stock can be sold for a profit.
Another factor that should be considered by investors is the bid volume and ask volume. These represent the number of transactions being conducted at the bid and ask prices. If more transactions are happening at the bid price than the ask price, the price of the asset is more likely to go down. Conversely, when the opposite occurs and more transactions are taking place at the ask price, the price is more likely to move up. Understanding this helps investors to better time their buy and sell orders.
Market makers: facilitating instantaneous buy and sell
To facilitate the sale of stocks and other assets, brokerage firms and other stock dealers step in to play the role of “market makers.” Market makers are high-volume traders who stand by with securities and are ready to buy and sell at any moment in time. They do this by placing bids and asks on the same stock simultaneously, allowing other traders to buy or sell the stock from them. This increases market liquidity by making it easier for buyers and sellers to connect and complete transactions. The market maker profits on these transactions from the bid-ask spread.
Playing the role of market maker does not come without risks, however. If they are not able to sell the stocks they purchase immediately, the stock could lose value, costing the market maker. If the stock value falls dramatically, the loss to the market maker is considerable. The profit that market makers make from the bid-ask spread is justified by the risks that they assume.
Overall, investors must be aware that stock prices are driven in large part by the supply and demand that plays out in bids and asks. The spread between the bid and ask impacts the cost of trading. When using market makers to conduct transactions, investors will typically pay the spread in exchange for convenience and liquidity. Therefore, that cost needs to be considered when evaluating whether a stock trade is profitable.
Charles Qi is the CEO and Founder of StockPick, a video-based investing social network for retail investors. Prior to StockPick, Charles spent over a decade at CIBC Capital Markets, a top Canadian investment bank, where he was an Executive Director and Quantitative Investment Strategist and oversaw more than CAD$1 billion institutional assets. Charles is a CFA Charter holder and holds a Master’s Degree in computational finance from Carnegie Mellon University.