What is the Inside Market?
The inside market is the spread between the highest bid price and lowest ask price among various market makers in a particular security. Typically, price quotes between market makers feature a lower ask and a higher bid than the quotes made to retail investors in the same security.
The inside market bid is referred to as the inside bid, and the inside market ask is referred to as the inside ask or offer.
- The inside price is the highest bid and lowest offer in a security. Historically this was provided by a market maker, but in the electronic trading age, it may be created by other participants as well.
- The inside price creates the spread between the bid and ask. Bids below and asks above the inside price appear on the order book or Level II.
- If a bid/offer is fully removed or fully filled, the next highest bid or lowest offer becomes part of the inside market price.
Understanding the Inside Market
The inside market, as it relates to market makers, has taken on a smaller role since the introduction of discount brokers and electronic exchanges. Market makers no longer play as active of a role in the majority of transactions which take place on a stock exchange, compared to before decimalization. Therefore, the inside market is the highest bid and lowest ask, regardless of who is posted those bids and offers.
Retail clients with direct access to the markets can place their own bids and asks, narrowing the spread (if it's wider than $0.01 in a stock), creating a new inside market. While a market maker may create an inside market, it doesn't always have to be the market marker creating it.
An active day trader focusing on one stock could end up taking on the role of an unofficial market maker, buying and selling frequently, providing liquidity when others are looking for it, capturing the spread, profiting from price moves, and frequently creating the inside market.
Highly traded products such as currencies, blue-chip stocks, and large exchange traded funds (ETFs) will have small inside markets because of the high trade volume and a large number of participants. By contrast, relatively unknown or small companies may have a very little volume, and therefore a large bid/ask spread and inside market.
As volatility rises, the inside market will increase in all financial products due to uncertainty. This was prevalent during the Great Recession when investors looking to exit trades had to cross wide spreads with significantly large inside markets to execute those deals.
Spreads may also get wider during good news. A positive earnings report may see a stock shoot higher, yet because the participants are searching to find the appropriate price following the announcement the market makers and active traders will want to be compensated for trading in the aftermath of the news, and therefore they will post lower bids and higher offers than they typically would. Under normal conditions, the stock may trade with a $0.01 spread, but following news (good or bad) it may trade with a $0.10 or $0.20 spread, for example.
Bids, Asks, and Outside Prices
Traders, investors, and market makers posts bids and asks at different prices. The highest bid and lowest ask form the inside market. There may be multiple traders at this price, for example, a market maker may be bidding 500 shares, while another trader has a bid for 200, and a longer-term investor has a bid for 100. The same concept applies to the ask.
If all the shares at the bid are removed or filled, the bids at the next highest price will become part (the bid) of the inside market.
The bids that are posted below the highest bid, and the offers that are posted above the lowest ask, are outside the inside price. These orders can be seen on the order book or Level II screen.
Example of Inside Market
Bank of America Corporation (BAC) is a heavily traded stock, averaging over 50 million shares per day. The spread is typically $0.01, and at each price level at or below the current bid there will be multiple participants posting their interest to buy in different volumes. Same goes for the offer. At the offer, and at each price above it, there will be offers to sell in different volumes.
Assume that the current bid is $27.90 and the current ask is $27.91. This is the inside market.
The offer has 225,000 shares posted on multiple ECNS and on the NYSE by multiple traders and market makers.
Traders, investors, and market makers can buy from those currently offered at $27.91, or they can add themselves to the queue of people who are bidding at $27.90. They may also choose to bid at a lower price of their choosing.
Those that want to sell can sell or short by transacting with the people bidding at $27.90, or they can post an offer to sell at $27.91 or above.
Now assume that all the offers at $27.91 are filled. The next ask price is $27.92. Those that wanted to buy at $27.91 no longer have offers to buy from, so instead, they start placing bids at $27.91. The inside market has shifted from $27.90 by $27.91 to $27.91 by $27.92. This process continues throughout the day causing the price to oscillate higher and lower.