The bid-ask spread is the price difference between where someone is willing to buy and someone is willing to sell. The bid is the highest publicized price someone is willing to pay for an asset. The offer is the lowest publicized price someone is willing to sell an asset for.
Publicized means an order has been placed on the exchange and is visible to other traders. If a stock has recently traded at $50.50, I may be willing to pay much more than that, but I still have the option to place a bid at $50.50, or $50.47, or $35 for that matter.
Someone else may be willing to sell at $50.55 right now. A buyer could transact with that person and buy at $50.55, or they could place a bid at $50.52, or any price lower than the current ask (at or above the ask price creates an instant transaction) and hope someone sells to them at this lower price.
Whatever price the most recent transaction occurred at is called the last price. For a transaction to occur, someone must sell to a bidder or buy from someone selling.
If the bid is 50.52 and the offer is 50.55, that’s a 0.03 spread. If the bid is 125 and the offer is 126, the spread is 1.0. If the last trade price was 126, then that is the last price.
The last price is often quoted as the price on financial news sites.
The ask price is also called the offer price.
Bids and offers are created by placing an order. There are various order types, so we’ll discuss those a bit later on.
Bids and asks are a feature of all financial markets, including stocks, forex, futures, options, cryptocurrencies, and so on.
I’ll use stocks for discussing the main points, but when will provide some examples for other markets as well.
The Bid-Ask is How Prices Move
Prices move based on whether transactions go through at the bid or the offer.
Assume the following scenario. On the left are people bidding, including how many shares and at what price they have placed an order to buy at. On the right are people offering their shares, including how many and at what price.
|Shares||Buyers (Bid)||Sellers (Ask)||Shares|
Assume someone buys the 500 shares at 50.03. Now that offer is gone and the next offer price is 50.04.
Assume someone buys the 300 shares at 50.04. Now the offer is 50.05 and the last transaction price is higher than the prior transaction, so the price is now moving up.
As the offer moves, often the bid price does as well. Maybe the 200 shares at 50.05 are sold as well, now the offer is 50.06. By this time the offer has likely moved up, but it may not have, it may still be at 50.02
If the offer is 50.06 and the bid is 50.02, that is a 0.04 spread; the difference between the bid and ask prices.
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How Orders Affect the Bid-Ask Spread
Traders have multiple order types at their disposal.
A common order is called the “Limit“. It limits the price we buy or sell at.
Using the above table, if we wanted to buy this stock, we could place a limit order at any price we want, and the price we set is the maximum price the order will fill at.
We could place a limit order at $45. In this case, the price will need to fall in order for our order to fill. Our order is filled if someone sells to us at $45.
We could also place a Limit at $50, pretty close to the current price. Only a few bids are above us. Or we could place a limit at $50.10. Since our order is above the offer price, it will fill right away, buying the shares starting at $50.03. If we are buying 1000 shares up to $50.10, we will receive 500 at $50.03, 300 at $50.04, and 200 at $50.05. That will complete our order and assuming nothing changes the offer price will now be $50.06.
“Market” orders are another common type of order. When we send a market order to buy or sell, it will instantly transact with whoever it can.
For example, placing a market sell order for 500 shares will instantly sell 300 at $50.02 and 200 at $50.01 because there are willing buyers at those prices for us to sell to. The new bid price would be 50.
Bid-Ask Prices Change Quickly
The price we see isn’t always the price we get.
If there’s an offer at 35.36, and we use a market or limit order to buy at 35.36, maybe we get the shares at that price or maybe we don’t.
In active stocks, hundreds of orders and transactions can go through each minute. Someone else might have hit their buy button a millisecond before you, and they get the shares. Or the person who was selling may have changed their mind and canceled the order a split second before you decided to buy them.
In an active stock, the bid and ask prices will rapidly change.
Transactions Create Volume and Volatility
Volume is how many shares change hands in a day.
If someone is selling 100 shares and you buy them, that creates 100 shares of volume.
Day traders and swing traders prefer stocks that do lots of volume, typically at least 100,000 shares or more per day, and often 1million or even 5million+ per day.
Stocks with high volume tend to have smaller bid-ask spreads. This is because there are many buyers and sellers.
Stocks with fewer buyers and sellers tend to have wider spreads.
This isn’t always the case though. If a stock (or any asset) is very volatile, it will tend to have a larger bid-ask spread.
How Supply and Demand Moves the Bid-Ask Spread, Prices, and Creates Trends
We already discussed how transactions affect and move the bid and ask prices. I gave the example of the offers being bought which increases the offer price.
On a one-minute chart, this process will show the price moving up, because people are buying at higher (offer) prices. The bids may also be moving up, so even though people may be selling, overall the price is rising.
This short-term process also creates long-term uptrends and downtrends. When a stock rises over the course of the year, that is because, on average, people were buying at higher (offer) prices and also bidding at higher prices.
If more or larger transactions start occurring at the bid, and the bid and offer prices start dropping, this can create a downtrend. For whatever reason, in this case, buyers are only willing to buy at lower prices and sellers are willing to sell at lower prices (usually because they think the price is going even lower).
Examples of the Bid-Ask Spread in Forex
Nearly all the same concepts discussed above apply to forex as well.
- There are bid and ask prices.
- The difference between them is the spread.
- As people are willing to buy/sell at higher prices, the price goes up. As people sell/buy at lower prices the price goes down.
- High volatility tends to increase the bid-ask spread.
- High volume tends to decrease the bid-ask spread.
- Orders create the bids and asks and also cause the transactions which create volume, volatility, and price changes.
One main difference is that most forex brokers don’t quote the last price traded. Instead, charts show the current bid price. A bank may only quote you their bid price if you are selling currency and may only quote you their offer price if you are buying currency.
Instead of shares, volume in forex is “lots”. A lot is either 1000, 10,000, or 100,000 worth of currency, called micro, mini, and standard lots respectively.
Here’s an example of what the bid-ask spread looks like in the EURUSD, the most heavily traded currency pair in the world.
The highest current bid is 1.05449 and the lowest offer is 1.05452, creating a spread of 0.00003, or 0.3 pips (a pip is the fourth decimal place in JPY pairs, like this one).
People are bidding a total of 10 standard lots at 1.05449, and 7.03 lots at 1.05448.
People are offering a total of 25 standard lots at 1.05452 and 23.28 standard lots at 1.05453.
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Cory Mitchell, CMT
Disclaimer: Nothing in this article is personal investment advice, or advice to buy or sell anything. Trading is risky and can result in substantial losses, even more than deposited if using leverage.