Why The Bid-Ask Spread Is So Important:
In investing classes, a very simple question is often asked: what makes a stock go up or down? The interesting thing is that more than 85% of people don't quite know the answer and believe that buyers make a stock go up, sellers make it go down.
On the surface, that answer sounds pretty logical. A big sell-off surely makes a stock plunge, and a heavy buying spree makes it go up, right?
The problem is, that's only what seems to happen according to the evening news. This overgeneralization of the influences on stock price is adequate for an investor, but to be a trader, you need to understand much more about the small real-time movement process underlying the bigger day's results. At that level, a lot more is going on. For starters, did you ever stop to think that during a big sell off, there has to be just as many buyers as there are sellers? That's right: every transaction requires both.
This is where the bid-ask spread comes in, and while this concept may be a yawner for an investor, for a trader it is crucial information.
Bid-ask is all about supply and demand at the trade execution level, matching buyers and sellers and the process of price negotiation in the market. (To learn more about this process, read Understanding Order Execution.)
An important concept underlying bid-ask is scarcity. Beneath those huge trading volumes ("millions of XYZ shares changed hands today") is another trading secret: price tier scarcity.
Beneath those trading volumes is the fact that although a lot of XYZ's shares may be in play and available, only a limited number of shares are available at any given price tier: the one immediately surrounding the extremes shown in the ticker quote.
If 1,000 shares are available at tier A ($20) and you want 2,000, you will, in effect, briefly control a piece of the market when you buy all available at $20 and then eat into the next tier at 20-1/8.
What makes these tiers happen? If a seller has a limit order at an ask price of 20-1/4 (and thus no lower) and you have a limit order with a bid price of 20 (and thus no higher) spreads are created by the dynamic bid-ask negotiation and information tension between buyers and sellers. (For more on limit orders, see The Basics Of Order Entry and What is the difference between a stop and a limit order?)
A collection of limit orders will then create tiers or blocks of shares available and sought at various levels anchored to the strategy of traders, the last trade price and high/low quotes they are watching.
Limit orders might create these tiers for XYZ:
1,000 shares at 20
2,000 shares at 20-1/8
3,000 shares at 20-1/4
If your limit order bid of 20 (and no higher) matches an ask of 20 (and no lower), you will cause the stock to uptick as soon as your volume requirement exhausts the tier at that level. The supply is used up, demand still exists and trading equilibrium (or stalemate) is broken.
But what about the ticker itself? If there are all those tiers and orders out there, which ones do we see?
If XYZ is NYSE (three digits), the quote might look like:
20-20-1/4 200X50 50,000
$20 is the bid price. Of all the tiers and prices anywhere in the market, $20 at this moment is the highest price a buyer is willing to pay for XYZ. Since this has to be a limit order, the bidder is not willing to pay a dime more than $20.
Of all the selling tiers and orders in the market, at this moment, 20-1/4 is the ask price, or the lowest price a seller is willing to accept for XYZ. This is, in effect, the best offer in the market for XYZ at this moment in time.
Since both are limit orders, must a trade be executed? Absolutely not. These are merely the bait put out there by the pros as a negotiation tool.
Since we only see the extremes (the highest bid and the lowest ask) are we missing something? Yes. We are missing all the orders at prices that are considered "out of the market" - those tiers that are betting on a different valuation of XYZ.
