Ask and bid can be termed as two different sides of the same coin. Both of these are important for the smooth functioning of trading in a market. Without any one of these, the markets would not function smoothly.
A bid can be defined as the maximum amount a buyer is willing to pay for specific financial security. It can be anything from a stock to a bond. Even in our daily transactions, we unknowingly use Bid prices. Suppose that you will buy a used car; there is a maximum amount that you are willing to pay for a used car. Now, you are a buyer, and the bid is the maximum amount you are willing to pay for a car.
The ask is defined as the minimum price that a seller is willing to sell financial security for. The ask can also be for anything from a stock to a bond. Let’s take the example of used car buying. In that situation, you are the buyer, and the car salesman is the seller. Car Salesman also has a minimum selling price for the car in his/ her mind. He/ she is not willing to settle for anything less. So, the car salesman has an Ask in his/ her mind.
So, that is how ask and bid work. Both are essential components to make a deal.
What is Bid-Ask Spread?
The bid-ask spread or spread is the difference between the price that the buyer is willing to pay for a stock and the price the seller is willing to sell the stock for. The price differential is called the Bid-Ask spread.
The spread can also tell us a lot about how smoothly the market is working. It also tells us about liquidity in the market. So, if the Bid-Ask spread is small, it means there is ample liquidity in the market, and if the Bid-Ask spread is large, it means the market is deprived of liquidity. As we all know how much liquidity is important to the smooth functioning of the market. The Bid-Ask spread can be low for hot stocks or bonds and high for the stocks or bonds that are not traded much.
The Fed also keeps an eye on the spread of various financial products such as stocks and bonds to monitor the current conditions of the market.
Example of a stock
Take an example of a Stock A. The Bid-Ask spread for Stock A is $11/ 11.1. This is how the spreads are quoted. It means the buyer is willing to pay $11 for Stock A, while the seller’s minimum asking price is $11.1. There is a split of ten cents. This is just an example of a hypothetical stock. The spread can vary and depends on the company, type of bonds, and securities.
Who makes money from the spread?
The market makers are the ones who make money from the spread. A market maker plays both sides to make money. The main function of the market maker is to provide liquidity in the market. But, the market maker is also taking a whole lot of risk onto himself. Suppose that the market maker buys a stock for $10, but now that stock declined significantly, worth $5. Nobody would pay ten dollars for a stock that worths five dollars. So, the loss will be recorded in the books of the market maker. Hence, the spread can be termed as the commission of the market maker for providing liquidity in the market while presuming the risk associated with a particular stock, bond, or any other security.
So, if the spread widens it means that there are fewer buyers or sellers of the underlying security and that the market maker is charging more for the biggest risk the market maker is taking on. Market maker also makes money on the tight spread. Because, in a tight spread there is high volume, so the market maker charges less commission, but still makes money as there is a higher volume. This follows the same principle of scale, the more amount of a product you sell, the lower can you charge per unit, and still earn higher profits.
What to keep in mind about Bid-Ask Spread when trading?
Now, if you are looking to use the Bid-Ask spread for your advantage while trading in stocks, bonds, or foreign exchange, always trade by keeping these things in mind:
Trade-in higher volume securities
Always trade in higher volume securities because higher volume securities have the lowest spread, and these also provide the most liquidity. Because if you are paying a higher spread on securities, there is less chance of you using the money to earn profits, and instead, this money would go towards paying commission to the market maker. After all, that is how the market maker makes money.
For example, trade in high volume foreign exchange pairs such as USD-GBP, which have the lowest spread.
Trade during the right times
The spread does not remain the same, even for the same security in a single day. The spread keeps changing. So, choose times to trade when the spread is low. These are the times showing high volume trades. A usual time to trade would be just when the markets open at 9’o clock in the U.S.A. Also, after the lunch break, there is a very high volume of trades and as a result, the Bid-Ask spread is small.
So, trade during times when the volume is high so you play less spread. The market opening and after lunch are the high volume times, so try to trade during these times to take advantage of lower spreads.
The Bid price is the maximum amount of price a buyer is willing to pay for a security and the asking price is the minimum price a seller is willing to sell a security for. The Bid-ask spread is low when volumes are high and high when volumes are low. So, take advantage of spread and trade only when the spread is low.