Why the Bid and Ask Price Matter When Trading Stocks & ETFs
When you trade stocks, you know that every stock has a price listed on the exchange, and you usually expect to buy or sell shares for a price near the one listed.
However, only looking at the listed price can be dangerous.
There are two different prices, the bid price and the ask price, that investors need to be aware of if they want to be able to trade shares effectively.
These are the prices that people are currently willing to pay or accept when buying or selling a share.
The bid price of a stock is the highest price that someone is currently offering to buy shares in a company or ETF.
Picture a group of ten people, all wanting to buy a stock.
They each decide how much they’re willing to pay, then form a line in the order of highest price to lowest price. The person at the front of the line is willing to pay the most for a share, so their price becomes the bid price.
If someone wants to sell shares, they go talk to the person at the front of the line to complete the transaction.
When that person’s order is fulfilled, they leave the line and the price of the next person in line becomes the bid price. The next seller talks to the next person in line, whose price becomes the bid price.
In the real world:
Bid prices can change regularly as new traders show up and are willing to pay higher prices or people looking to buy decide not to buy, and the bid price drops to the next highest offer.
The ask price of a stock is the opposite of the bid price. It’s the lowest price at which any investor is willing to sell their shares.
Again, picture a group of ten investors, all looking to sell their shares in a company. Each decides the lowest price they’ll accept per share and get in line in order of lowest asking price to the highest.
Anyone looking to buy a share will go to the person selling for the lowest price until that person runs out of shares to sell. Then, the next lowest price becomes the ask price.
Again, in reality:
Ask prices change regularly as investors lower or raise the price that they’re willing to accept for their shares.
The spread is the difference between the bid price and the ask price of a stock.
There must always be a difference between the two because if the lowest ask price and highest bid price are equal, the stock exchange will facilitate transactions between people looking to buy and sell for the same price until there are no buyers at the ask price or no sellers at the bid price.
For most frequently-traded securities, the spread between the bid and ask price is very smaller, often as small as a penny.
For less liquid securities, the spread can be much larger.
This can be dangerous for investors who want to buy or sell shares of that security.
If the gulf between the bid and ask price means that you may have a hard time selling the shares you bought for anything near the price you paid.
Why Do They Matter to Investors?
The bid and ask price matter to investors because they impact the price that investors pay to buy shares or the money they receive when selling them.
- If you want to buy a share, you have to pay the ask price.
- If you want to sell shares, you’ll receive the bid price.
You can’t immediately buy a share and sell it and expect to get the same amount of money back.
Bid and ask prices can be especially relevant depending on the type of order you place.
Market orders are a type of order that executes as quickly as possible.
You simply tell your brokerage the number of shares that you want to buy or sell.
The brokerage will buy or sell that number of shares at the best available prices, meaning the bid/ask prices.
You could wind up paying a very different amount than you expect to if the ask prices are higher than you expect.
Similarly, you could sell shares for less than you intend if the bid prices are lower than expected.
With a limit order, you specify the number of shares to buy or sell and the maximum price you’re willing to pay or the minimum price you’re willing to sell for.
Your brokerage will buy or sell the shares at the best available price, but will stop if the bid price falls too low or the ask price rise
Difference Between the Last Price and Current Price
When you look at a stock ticker, you don’t usually see the bid and ask prices for a stock.
You’ll see a single number.
This is the last price at which a transaction occurred.
With high-volume stocks, you can usually expect the bid and ask prices (the current prices you can buy and sell shares at) to be very close to the last price listed on the stock ticker.
That means that it usually isn’t too risky to place a market order on a high-volume stock.
With companies that aren’t traded as frequently, there can be a huge difference between the last price and the bid and ask prices.
For example, a transaction may have occurred at $2 early in the morning, but by afternoon, the ask price might have risen to $5. If you go to buy shares expecting to pay $2 each, you could be very surprised when you pay more than double that amount.
Similarly, if you try to sell shares, you might wind up selling them for far less than the $2 that you expected to.
Risk Related to a Bid/Ask Spread
If there is a large bid/ask spread in a stock, that can make it very risky to buy shares.
Large bid/ask spreads make it hard to buy or sell shares in a timely manner.
This is most common with small companies with infrequently traded stocks.
Consider this example. Company XYZ is a very small business. The current bid price for its shares is $1 while the ask price is $3. That makes the spread $2.
If you want to buy shares in XYZ without waiting, you have to pay $3 per share. If you turn around and sell those shares, you either have to place a limit order and wait or accept just $1 each. You’d lose $2 per share.
To sell your shares for a breakeven price, you need the bid price to rise by a large amount, which means the underlying company likely needs to gain significant value.
It also means that if you have to sell your shares in an emergency, you’ll have to accept a significant loss.
While you usually only see a single price quoted for stocks traded on the stock market, that price doesn’t tell the whole story.
The bid and ask prices are the prices that investors should really care about, because they show the real prices at which you can buy or sell a share.