Monday, March 1, 2010

Bid-ask spread

What is the bid-ask spread?

You have done your analysis, have some money ready to be put to work and have decided to buy a stock because you have reasonable expectations that it will go up eventually netting you a profit.

So you go to your broker's interface and locate the stock that you intend to buy (by using its ticker symbol or looking it up) and decide to get a quote on it. Immediately you notice that there is a lot of information (last trade, change from last trading day's close, volume, etc) but most strikingly you notice that for the stock you are looking at you have three prices: the price that the stock last traded at, a bid and an ask.

You understand the stock price as it is clear that this is the price at which the last transaction took place but what exactly are bid and ask prices?

When you go to an exchange to buy a stock (which is essentially what your broker allows you to do through its interface), you are taking place in an actual market, in this case for stocks. what this means is that, not unlike an open market for anything else (clothes, produce, books, etc), there are people who currently have something they want to sell and also people who don't have that same thing and want to buy it. The market allows buyers and sellers to come together and determine a price at which a seller is willing to sell and a buyer is willing to buy and when there is agreement and a transaction takes place we can say that the market price has been determined.

As you might expect, buyers want to pay as little as possible for what they are buying and sellers want to get as much as they can for what they are about to sell. That is why you have two prices in the market. The bid price is the price that someone that wants to buy is currently bidding. This means that they are willing to pay that price if someone else wants to sell their shares immediately. The ask price (also called offer price) is the price that someone is willing to sell at at that moment. In other words, when you look at a stock quote and see a bid and an ask that means that the bid is what you could immediately sell your stock at (if you already have the shares and want to sell them) and the ask price is the price that you could immediately buy the stock at from someone who is willing to take the price that they are offering the shares at.

The difference between the bid and the ask price is called the spread. The spread is the difference between the price that you pay to buy a stock compared to the price you could sell your stock at that same time. In other words, if you were to buy a stock and immediately turn around and sell it you would have a small loss in the amount of the spread. This is something that is similar to going and exchanging some money into a foreign currency. You will notice that the institutions (bank, foreign exchange centre, etc.) are always willing to sell you the foreign currency at a higher currency exchange rate that they are willing to buy them from you. That difference is the spread and is a profit for them and a cost for you.

If you think about it, the spread is a cost of doing business since you are always going to have to buy at a higher price than you could theoretically sell the same thing for.  When you invest or trade you have to factor in two major costs to every transaction: the actual transaction brokerage fee (also called commission) and also the cost represented by the bid/ask spread.

The bid/ask spread can be looked at as being a representation of the liquidity of a stock. Liquidity is a measure of how easy it is to buy and sell a certain stock and is normally represented by the trading volume. If there's a large number of shares of a certain company changing hands then that stock is said to be very liquid, meaning that there is almost always someone willing to buy and someone willing to sell those shares. The market being a naturally competitive place, the more liquid a stock is the tighter the spread will be, since there are more buyers and sellers competing with each other and thus offering higher prices they are willing to buy at (bid) and lower prices they are willing to sell at (ask).

From a practical investing and trading perspective, it is always recomended that you favor liquid stocks (by looking at high daily trading volume and tight bid/ask spreads) since those are the ones where you will end up paying less in terms of the bid/ask spread over the long run. Also, tight bid/ask spread normally imply less volatilty since wild price swings normally happen to stocks where there are not a lot of buyers and sellers and/or the trading volume is lower and bid/ask spreads are higher (as is the case for example for penny stocks). Also, if there is sufficient liquidity it is more liquely that your stop losses (something we will talk about in an upcoming article) get properly executed and therefore provide you with one of the main risk management tool that you will use while investing or trading.

In the US markets, bid/ask spreads used to be fractional (i.e. the minimum bid/ask spread or tick was 1/16th of a dollar or around 6.25 cents) but starting in 2001 the market switched over to decimals and now the minimum spread is one cent which is what you normally see in most highly liquid stocks trading in the US.