What is an Inside Quote
Inside quotes are the best bid and ask prices offered to buy and sell a security amongst the competing market makers.
BREAKING DOWN Inside Quote
Inside quotes are a central part of exchange infrastructure trading. These quotes are communicated to market makers who seek to connect buyers and sellers through a bid-ask trading process. Generally inside quotes are only viewed by market makers through exchange trading systems however these quotes are reflected in the price at which trades occur.
Bid-Ask Trading Process
The bid-ask trading process is what facilitates the execution of trades on a market exchange. Market makers may be individual traders or computer systems facilitating trades. These market makers use inside quotes to determine price levels which then generate a profit from a resulting bid-ask spread.
Inside bid and ask prices are quoted for the market maker. Therefore, a market maker seeking to execute a buy order will seek to identify the lowest bid order quote and the highest ask order quote to generate the largest bid-ask spread for a profit.
In the execution of a sell order, the same scenario generally occurs. The market maker must still identify a buyer to exchange shares from the sell order. Thus, the market maker agrees to buy the shares at the inside bid price and sell the shares at a higher inside ask price. For the market maker to execute a trade, the ask price must always be higher than the bid price to ensure a profit from the bid-ask spread.
Supply, Demand and Liquidity
In general when supply goes up, prices go down and demand goes down as well. Inversely, when demand is high, prices increase and supply is relatively lower.
In the securities markets, a high supply of a security results from a higher number of investors wishing to sell. When supply is high it pushes the price down. Adversely, increased demand for a security results from a higher number of interested buyers which will cause a reduction in the supply and an increase in the price. Overall, supply and demand drive liquidity which is the greatest variable involved in the bid-ask spread. When spreads are wider it shows lower liquidity. When spreads are tighter it shows higher liquidity with more rapidly changing price quotes.
As an example, consider a market maker seeking to execute a trade on XYZ stock. Demand is high for the stock and there are multiple buyers willing to pay a relatively high price. Alternatively supply is low and fewer owners of the stock are willing to sell, requiring a higher selling price overall. Bid-ask spreads will typically be wider in this scenario, allowing a market maker to earn a greater profit.
When supply for a stock is high but demand is low it can decrease the market liquidity and cause fewer trades to be executed since a market maker has less of an opportunity to earn a profit. In this scenario market makers must identify buyers to match with sellers and if fewer buyers are available at adequate price levels, then it can decrease the liquidity overall and result in an unprofitable crossed market.