Veteran traders throw terms like bid vs ask around like NFL players throw a football. Precision is key to their success in both arenas. Have a spread too wide, and you miss the throw. Watch our video on bid vs ask spreads and their importance when trading.
Have a bid and ask too big, and you miss out on profits. So that you might avoid this dilemma, I'd like to run through some important considerations when trading stocks with large bid vs. ask spreads.
Bid vs Ask Defined
- The bid price of a stock represents the highest price someone is willing to pay for a share. Alternatively, the ask is the lowest price someone is willing to sell their shares for. The end result? A difference in price between the bid and the ask, which we call a spread.
1. A Five Minute Summary
- We call the difference between the highest purchase price and the lowest sales price for a stock as the bid-ask spread
- Any highly liquid stock typically has a narrow spread, whereas thinly traded stocks usually have wider spreads.
- Bid and ask refers to a stocks demand in the market
- Use limit orders, price discovery and all-or-none orders when trading stocks with large bid vs. ask spreads
2. The Importance of Supply and Demand
Anything in high demand means you can charge more. From prime real estate in LA to toilet paper during a pandemic, high demand means higher prices. And it's no different when it comes to stocks.
We use terms like bid and ask to refer to the stock's supply and demand on the market. The highest price someone is willing to pay for a stock represents the demand side of the market.
On the other hand, the lowest possible price someone is willing to sell represents the market's supply side. At this point, it shouldn't come as a surprise that low demand for a stock means lower prices.
3. Two Critical Factors That Determine the Bid vs Ask Spread
Without a doubt, the primary determinant of the bid-ask spread size is volume. In my experience, low volume or thinly traded stocks tend to have higher spreads.
One additional point of consideration is market volatility. In times of heightened volatility, spreads usually widen, leaving us with poor trade price executions.
How Do You Read the Bid/Ask Spread?
- The bid vs ask spread is really important in trading. So how do you read it? The bid/ask spread is basically the difference between the highest price willing to pay vs the lowest price a seller will accept. In other words, the bid represents demand and the ask represents supply. Knowing that could help you become a market maker ha!
A stocks trading volume refers to the number of shares traded during a specific period. The resulting number measures the liquidity of the stock.
Typically, ETF's and large-cap stocks like Apple are highly liquid with narrow spreads. Many traders look to trade these stocks because they can easily get filled at the price they want.
Unlike highly liquid stocks that are easy to trade, low volume stocks can prove to be difficult. Few traders are interested in them, and they can be hard to unload if you hold them. For these reasons, market makers often use wider bid-ask spreads to offset the risk of holding these illiquid securities.
In case you're wondering, market makers have a duty to ensure efficient functioning markets by providing liquidity. On a more positive note, a wide bid vs. ask spread means a higher premium for the market makers.
Volatility measures the severity of price changes in a stock or any security for that matter. In situations of high volatility, we see drastic price changes.
One characteristic of high volatile environments are wide bid vs ask spreads. Traders and investors alike try to capitalize on these agitated market conditions.
3. Bid vs Ask And Order Fulfillment
Like anything in life, there's a constant push-pull between buyers and sellers. Buyers want to buy low, and sellers want to sell high. It is not until the bid vs. ask matches that an order to buy or sell is filled.
Unfortunately, if no orders bridge the bid-ask spread, there will be no trades executed. A situation like this puts the market in a tricky position. Thus, to maintain effective functioning markets, market makers quote both bid and ask prices when no orders cross the spread.
Consider company AMD; it has a bid of 100 shares at $9.95, and an ask of 200 shares at $10.05. Unless a buyer meets the asking price or a seller meets the bidding price, a trade doesn't happen.
Suppose Dan places a market order to buy 100 shares of AMD. As a market order, this means he's willing to pay the current market price. Thus, the bid price would become $10.05, and the shares are traded until the order is filled. Furthermore, once the 100 shares are traded, the bid will revert to $9.95, as it's the next highest bid order.
4. We Need to Talk About Slippage
Let's look at a real life example of a stock with a bid vs. ask spread of $12.00-$12.02. You're eager to get in, so you place a market order thinking you'll get executed immediately at $12.00. Right? Wrong.
Unfortunately for you, when your market order arrived at the Exchange, the stock has already soared to $12.15 on news. Unfortunately for you, your buy market order gets filled at $12.15, and you realize a slippage of 15 cents. And that is bad, really, bad.
Slippage happens when you place market orders. To refresh your memory, if you're placing a market order, you are telling your broker to immediately buy or sell the stock for you at any price. Yes, at any price.
You have no control over the fill price. A market order buys at the ask (high side) and sells at the bid (low side). Sadly you find yourself filled on the wrong side of the bid-ask spread. You need to avoid this situation at all costs.
How to Trade Stocks With Wide Bid vs Ask Spreads
- To manage the risks associated with wide spreads (i.e. slippage), traders should consider using limit orders, price discovery and all-or-none orders. With options based credit spreads, bid/ask spreads are important! Let's take a look at this a little bit closer.
1. Use Limit Orders
Instead of blindly entering a trade with a market order, place a limit order. A limit order will help you to avoid paying excessive spreads and control your entry price. Unlike a market order, a limit order only fills at the price you want, or better.
What is key to remember is a limit order limits the price you are willing to pay for the stock. You tell your broker to buy or sell a specific stock at or better than a set price specified by you. The important thing is: you avoid slippage. You are in control of your trades, and this should be your ultimate goal.
Let's assume Dan wants to purchase a marijuana penny stock with a bid of 30 cents and an ask of 50 cents. If he placed a market order, he buys at 50 cents; this is not what Dan should do for obvious reasons.
What Dan could do is enter a buy limit order at 31 cents. At 31 cents, he's at the top of the ladder, above all the other buyers at 30 cents. His order gets filled first because he has first priority with the 1 cent higher price.
Alternatively, if Dan was long and wants to sell, he could place a sell limit order at 49 cents - the top of the offer. If you recall from the first scenario, he shouldn't place a market sell order as he'll get filled at the bid price.
2. Price Discovery
Like I mentioned above, stocks with wide bid vs. ask spreads trade infrequently. Even if you trade with limit orders, they can sit unexecuted on the bid or ask for days.
To avoid this scenario, why don't you run a test on the market? You can simply increase the buy limit price and decreasing the sell limit price by small increments.
For example, if Dan sits at the top of the bid at $1.00, and the best offer is $1.25, he could perform price discovery. For starters, he could raise his limit order by 5 cents every day to see if the seller will come down on her bid price.
3. Avoid All-or-None Orders Like the Plague
All-or-nothing orders specify that either all of the total number of shares bought or sold gets executed, or none of them do. Liquidity is often thin in wide bid vs spread markets, which means you might miss out on a fill if only a small amount of stock gets traded.
For instance, if Dan placed an all-or-none buy limit order for 10,000 shares at $1.00 and Ali enters the market with 9,999 shares to sell at the bid price, the trade wouldn't execute.
Despite having the money to spend, there's simply a shortage of shares to completely fill his order. Even though it's only one share short, he misses out.
Some Bid vs Ask Final Advice
Stocks with wide bid vs ask spreads can be risky for many reasons. Whether it's poor fill price or the inability to exit a trade, you need to be careful when trading them.
During volatile conditions, traders would be wise not to place market orders unless they are completely necessary. Fundamentally the best way to prevent slippage is to utilize a guaranteed stop (limit) order. This type of order will always execute trades at the price you've set.
I know all this information can seem overwhelming, but Bullish Bears teaches you how to throw the winning touchdown. We make learning how to trade simple and easy to understand. Join us today for steep discounts on your membership; your winning trade is just a football throw away.