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. Not all quotes are visibly displayed on the order book. Therefore, there may be an inside quote "inside" of the quotes that retail investors see. That said, Regulation National Market System (NMS) states that investors must receive the best price available as it relates to publicly displayed orders. In other words, an investor's order can't be filled at a worse price than what is visibly showing on the order book.
- Inside quotes are undisplayed orders where the inside bid is higher than the displayed bid and inside ask is lower than the displayed ask price.
- Inside quotes are commonly associated with market makers, but anyone with access to certain advanced order types, dark pools, or hidden orders could create an inside order.
- Inside quotes are not visible on the order book, but when there is a transaction at an inside quote price it will show up on the time and sales.
Understanding the Inside Quote
Inside quotes are communicated between market makers who seek to connect buyers and sellers through a bid-ask trading process. Generally, inside quotes are only viewed by market makers and sophisticated traders. However, these quotes are reflected in the price at which trades occur.
In the modern electronic age of trading where retail investors can have direct market access and low trading fees, the market makers role has been diminished. Typically the prints on the time and sales will match the bid and offer. The exception is when a dark pool, or an electronic communication network (ECN) is matching orders with price improvement. This could be considered an inside quote, although it doesn't necessarily need to be instigated by a market maker. Some retail traders with advanced order and ECN capabilities can also initiate these orders.
Assume for a moment the order book shows a bid of $125.65 and an offer of $125.75. You go to buy shares at $125.75 but the order actually fills at $125.70. Someone posted a hidden order to sell at $125.70, which you were able to buy from. Since the order is hidden from the order book, it is not subject to Regulation NMS in the typical sense. It is not publicly displayed, so in some cases, it may only be hit if a certain ECN or order type is used. These order types may only be accessed by market markers, automated trading platforms, or sophisticated investors. This is essentially an inside quote.
The inside quote is a price that is not publicly displayed, but that is inside the order book quotes. For example, an inside bid is higher than the order book bid and the inside offer is lower than the order book offer.
Most of the time, and in many stocks, there is no inside quote. The order book quotes are the best prices available. If there are inside orders or dark orders, as discussed above, the price these orders are executing at will be displayed on the time and sales.
Bid-Ask Trading Process
The inside quote is part of the bid and ask trading process, whereby there are always two prices: the bid and ask.
The best bid is the highest price displayed by someone willing to buy. There will be additional bids at lower prices. The best ask is the lowest price displayed by someone willing to sell. There will be additional ask/sell orders above the best ask price.
Traders can view the current bids and asks and then decide how they want to proceed. They can either buy from the ask, or sell to the bid. This is called paying the spread.
They can also join the bid by posting a buy order at that price, or they can join the ask by posting a sell (or short sale) order at that price. They can also post a bid to buy below the best bid, or a sell order above the best ask.
Traders constantly reshuffling their bids and asks, and other traders interacting with orders, is what causes prices to move. In an actively traded stock, the bid and ask prices—and the quantities of shares available at those prices—will change by the second.
Due to Regulation NMS, an order cannot trade through the best bid or best offer. Meaning, if someone buys, it must be filled at the best ask price that is visibly available. If there is an offer for 100 shares at $36.50, a buy order for 100 shares or less must be filled at that price first (if that price is still available when the order reaches the exchange) and not at $36.55 for example.
Example of an Inside Quote in an Active Stock
Actively traded stocks will often have a $0.01 spread between the bid and ask. For example, the bid is 2,000 shares to buy at $27.25 and the ask is 3,000 shares at a price of $27.26.
A dark pool may be offering to sell at $27.255. This is a form of inside quote; not everyone may have access to buy off of that order. Also, many retail traders may not even know the order is there since it is not posted on the order book: the order is "dark."
The only way people will know the order is/was there is because a transaction at $27.255 will appear on the time and sales. Alternatively, if a common order type is routed through the dark pool or hidden order, then retail traders will notice price improvement on their buy order. They were expecting to buy at $27.26, but instead were filled at $25.255 by a hidden order or inside offer.