The terms spread, or bid-ask spread, is essential for stock market investors, but many people may not know what it means or how it relates to the stock market. The bid-ask spread can affect the price at which a purchase or sale is made, and thus an investor's overall portfolio return.
Supply and Demand
Investors must first understand the concept of supply and demand before learning the ins and outs of the spread. Supply refers to the volume or abundance of a particular item in the marketplace, such as the supply of stock for sale. Demand refers to an individual's willingness to pay a particular price for an item or stock.
- The bid-ask spread is largely dependant on liquidity—the more liquid a stock, the tighter spread.
- When an order is placed, the buyer or seller has an obligation to purchase or sell their shares at the agreed upon price.
- Different types of orders trigger different order placements. Some order types, like fill-or-kills, mean that if the exact order is not available, it will not be filled by the broker.
An Example of the Bid-Ask Spread
The spread is the difference between the bid price and ask price prices for a particular security.
For example, assume Morgan Stanley Capital International (MSCI) wants to purchase 1,000 shares of XYZ stock at $10, and Merrill Lynch wants to sell 1,500 shares at $10.25. The spread is the difference between the asking price of $10.25 and the bid price $10, or 25 cents.
An individual investor looking at this spread would then know that, if they want to sell 1,000 shares, they could do so at $10 by selling to MSCI. Conversely, the same investor would know that they could purchase 1,500 shares from Merrill Lynch at $10.25.
The size of the spread and price of the stock are determined by supply and demand. The more individual investors or companies that want to buy, the more bids there will be, while more sellers would result in more offers or asks.
How the Spread Is Matched
On the New York Stock Exchange (NYSE), a buyer and seller may be matched by a computer. However, in some instances, a specialist who handles the stock in question will match buyers and sellers on the exchange floor. In the absence of buyers and sellers, this person will also post bids or offers for the stock to maintain an orderly market.
On the Nasdaq, a market maker will use a computer system to post bids and offers, essentially playing the same role as a specialist. However, there is no physical floor. All orders are marked electronically.
Obligations for Placed Orders
When a firm posts a top bid or ask and is hit by an order, it must abide by its posting. In other words, in the example above, if MSCI posts the highest bid for 1,000 shares of stock and a seller places an order to sell 1,000 shares to the company, MSCI must honor its bid. The same is true for ask prices.
In short, the bid-ask spread is always to the disadvantage of the retail investor regardless of whether they are buying or selling. The price differential, or spread, between the bid and ask prices is determined by the overall supply and demand for the investment asset, which affects the asset's trading liquidity.
Popular and heavily traded stocks have significantly lower bid-ask spreads, while thinly traded stocks in low demand have significantly higher bid-ask spreads.
The primary consideration for an investor considering a stock purchase, in terms of the bid-ask spread, is simply the question of how confident they are that the stock's price will advance to a point where it will have significantly overcome the obstacle to profit that the bid-ask spread presents. For example, consider a stock that is trading with a bid price of $7 and an ask price of $9.
If the investor purchases the stock, it will have to advance to $10 a share simply to produce a $1 per-share profit for the investor. However, if the investor considers the stock likely to advance to a price of $25 to $30 a share, then they have an expectation that the stock will show a very significant profit beyond the $9 per-share ask price that must be paid to acquire the stock.
Types of Orders
An individual can place five types of orders with a specialist or market maker:
- Market Order – A market order can be filled at the market or prevailing price. By using the example above, if the buyer were to place an order to buy 1,500 shares, the buyer would receive 1,500 shares at the asking price of $10.25. If they placed a market order for 2,000 shares, the buyer would get 1,500 shares at $10.25 and 500 shares at the next best offer price, which might be higher than $10.25.
- Limit Order – An individual places a limit order to sell or buy a certain amount of stock at a given price or better. Using the above spread example, an individual might place a limit order to sell 2,000 shares at $10. Upon placing such an order, the individual would immediately sell 1,000 shares at the existing offer of $10. Then, they might have to wait until another buyer comes along and bids $10 or better to fill the balance of the order. Again, the balance of the stock will not be sold unless the shares trade at $10 or above. If the stock stays below $10 a share, the seller might never be able to unload the stock. The key point an investor using limit orders must keep in mind is that if they are trying to buy, then the asking price, not merely the bid price, must fall to the level of their limit order price, or below, for the order to be filled.
- Day Order – A day order is good only for that trading day. If it is not filled that day, the order is canceled.
- Fill or Kill (FOK) – An FOK order must be filled immediately and in its entirety or not at all. For example, if a person were to put in an FOK order to sell 2,000 shares at $10, a buyer would take in all 2,000 shares at that price immediately or refuse the order, in which case it would be canceled.
- Stop Order – A stop order goes to work when the stock passes a certain level. For example, suppose an investor wants to sell 1,000 shares of XYZ stock if it trades down to $9. In this case, the investor might place a stop order at $9 so that, when the stock does trade to that level, the order becomes effective as a market order. To be clear, this does not guarantee that the order will be executed at exactly $9, but it does guarantee that the stock will be sold. If sellers are abundant, the price at which the order is executed might be much lower than $9.
The Bottom Line
The bid-ask spread is essentially a negotiation in progress. To be successful, traders must be willing to take a stand and walk away in the bid-ask process through limit orders. By executing a market order without concern for the bid-ask and without insisting on a limit, traders are essentially confirming another trader's bid, creating a return for that trader.