The "bid" and the "ask" are two prices associated with stocks and other tradable securities. For any given stock, the bid is the highest price that someone is willing to pay to buy a share of that stock. The ask (sometimes call the "offer") is the lowest price at which someone is willing to sell that same share. In other words, the bid represents the fair price for a share from the buyers point of view, while the ask represents the fair price for a share from a seller's point of view.The bid will always be lower than the ask. The difference between the bid and the ask is referred to as the Bid/Ask Spread.
If you ever get confused, just remember: If you want to sell shares of company X stock, you will receive the lower price (the bid). If you want to buy shares of company X stock, you will pay the higher price (the ask).
Sell at bid, buy at ask.
Sell at bid, buy at ask.
Sell at bid, buy at ask.
Every stock exchange has designated entities known as "market makers" (there are thousands of market makers in the US). A market maker's job is to continuously post both a bid price and an ask price for a particular stock during the trading day. By standing ready to buy or sell a stock, the market maker ensures that there will always be someone ready to trade with an investor if the investor wants to sell or buy shares of that stock. If an investor wants to sell his shares, he knows he will receive the bid. If he wants to buy shares, his knows he will receive the ask. Without a market maker, the investor might not have been able to find someone willing to sell shares that investor wanted to buy (or buy shares that the investor wanted to sell).Thus, a market maker is "making a market", helping to maintain liquidity for a given stock.
What The Spread Really Represents
When you buy (or sell) shares of stock, the market maker is the one purchasing these shares from your stock broker (or selling these shares to your stock broker) if there is no one willing do take the opposite end of the trade at that time. The market maker is always standing ready to take the opposite end of a trade, and the market maker is required- by law- to fulfill orders at the bid and ask prices that it posts (in other words, the market maker cannot change it's mind if market conditions suddenly change).
Remember, an investor can sell a share (to the market maker) at the lower price, the bid, and an investor can buy that same share (from the market maker) at the higher price, the ask. The market maker buys low and sells high, pocketing the difference between the bid and the ask. In setting the bid/ask spread for a stock, the market maker is signaling how much he wants to be compensated for "making the market" for that stock.
Why should the market maker be compensated? After all, a market maker makes a hefty profit by pocketing the bid/ask spread (often referred to as "making the spread") on stocks with huge trading volumes.
In "making a market", a market maker must always stand ready to take the risk of holding the stocks that it is "making a market" in. The risk is that the market maker could buy the stock and then be unable to sell it to another investor later. In other words, the risk in "making a market" depends on the potential for sudden price swings that could occur while a market maker holds a particular security. The greater the risk, the wider the bid/ask spread.
The three major determinants of spread size are liquidity, volatility and stock price. Illiquid stocks, stocks being traded during periods of market volatility and cheap stocks will all tend to have wider spreads (note that we are referring to spread size as a percentage of stock price).
A liquid security is one that is trading at high volumes, while an illiquid security is one that is not trading much at all (a security that is not very liquid). Liquidity can also be thought of as the degree to which a security can be bought or sold in the market without affecting the security's price. When there is a high level of supply and demand for a stock, large sell or buy orders (aka sudden influxes of supply and demand) for that stock have less of an impact on the stock's price.
Liquid stocks tend to have narrow bid/ask spreads. The more people there are trading the stock, the quicker and easier it is for a market maker to "make the spread". Similarly, due to the high volume of trading, a liquid stock will tend to have multiple market makers competing to make a market in that security. Whichever market maker posts the most attractive bid and ask prices will attract the largest order flows, keeping the spread narrower than it would be otherwise.
Conversely, illiquid stocks have wider spreads. Because it takes longer to make the spread when there is less trading activity- and because a large buy or sell order can have a significant impact on the price of a thinly traded securities- the market maker is more exposed to the risk of a sudden price fluctuations when it is trading an illiquid security. A wider spread compensates the market maker for this risk.
The term for sudden price swings is "volatility", and it occurs when there are significant imbalances in supply and demand. During periods of heightened market volatility, stocks will have wider spreads; a market maker will want to receive greater compensation if he must always stand ready to trade a stock whose value is wildly fluctuating. Market makers will also post wider spreads during such periods in order to decrease the overall volume of trading.
Studies have shown that - on a percentage basis- cheap stocks have wider spreads. Stocks with low prices are usually from small to mid-cap companies and are not traded as heavily as large-cap stocks. Thus, cheap stocks are- by their nature- thinly traded. The market maker will demand a larger premium for trading cheap stocks due to their relative illiquidity.