Bid and ask: Meaning, Criticisms & Real-World Uses

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What Is Bid and Ask?

The "bid and ask," also known as the bid-ask spread, represents the two-tiered price quotation for a security or asset in the financial markets. It falls under the broader financial category of Market Microstructure. The bid price is the highest price a buyer is willing to pay for a security at a given time. Conversely, the ask price (or offer price) is the lowest price a seller is willing to accept for that same security. The difference between these two prices is the spread, which essentially represents the profit margin for a market maker or the cost of trading. Understanding the bid and ask is fundamental for investors placing orders and comprehending the real-time dynamics of price formation in markets.

History and Origin

The concept of bid and ask prices has been integral to financial markets since their inception, evolving from informal gatherings of traders to highly sophisticated electronic exchanges. Early stock exchanges, like the one formed under the Buttonwood Agreement in 1792, which laid the groundwork for the New York Stock Exchange (NYSE), relied on brokers verbally quoting prices they were willing to buy and sell at²¹, ²². These verbal declarations formed the nascent bid and ask, with brokers negotiating directly to find a mutually agreeable price.

As markets grew, so did the need for more formalized price discovery mechanisms. The evolution from a "call market," where securities were traded only at specific times, to a "continuous market," where trading occurs throughout the day, solidified the role of constant bid and ask quotations²⁰. The formalization of roles, such as the specialist on the NYSE floor, who maintained an order book and facilitated trading by quoting bid and ask prices, became crucial in ensuring orderly markets and providing liquidity. The advent of electronic trading platforms in the late 20th and early 21st centuries further revolutionized the bid and ask, making it instantly accessible to a global audience and narrowing spreads significantly due to increased competition and efficiency.

Key Takeaways

The bid price is the highest price a buyer is willing to pay for a security.
The ask price is the lowest price a seller is willing to accept for the same security.
The difference between the bid and ask is the spread, representing a trading cost or market maker's profit.
A tighter bid-ask spread generally indicates higher liquidity and lower transaction costs.
Understanding the bid and ask is crucial for placing effective buy or sell orders in financial markets.

Formula and Calculation

While there isn't a "formula" for the bid and ask themselves, the spread between them is a key calculation:

\text{Bid-Ask Spread} = \text{Ask Price} - \text{Bid Price}

For example, if a stock has a bid price of $$50.00$ and an ask price of $$50.05$, the bid-ask spread is $$0.05$. This spread is the immediate cost an investor incurs when crossing the market (i.e., buying at the ask or selling at the bid). The percentage bid-ask spread can also be calculated:

\text{Percentage Bid-Ask Spread} = \frac{\text{Ask Price} - \text{Bid Price}}{\text{Mid-Price}} \times 100

Where the Mid-Price is $\frac{\text{Ask Price} + \text{Bid Price}}{2}$.

These calculations are essential for evaluating the liquidity and efficiency of a market for a specific equity or other asset.

Interpreting the Bid and Ask

The bid and ask prices provide immediate insight into the supply and demand dynamics for a given security. A narrow bid-ask spread typically indicates high liquidity and active trading. This means there are many buyers and sellers in the market, making it easy to execute trades quickly and with minimal price impact. Conversely, a wide bid-ask spread often suggests lower liquidity, which can lead to higher transaction costs and potentially greater volatility for investors.

Investors should pay close attention to the bid and ask when placing orders. A market order to buy will typically be executed at the ask price, while a market order to sell will be executed at the bid price¹⁹. For investors seeking more control over their execution price, a limit order can be used, which specifies the maximum price to buy or minimum price to sell¹⁸.

Hypothetical Example

Consider XYZ Corp. stock currently showing a bid of $$25.00$ and an ask of $$25.02$.

Buying shares: If you place a market order to buy 100 shares of XYZ Corp., your order will likely be filled at the ask price of $$25.02$ per share. Your total cost would be $$2,502$ (100 shares x $$25.02$).
Selling shares: If you own 100 shares of XYZ Corp. and place a market order to sell, your order will likely be filled at the bid price of $$25.00$ per share. Your proceeds would be $$2,500$ (100 shares x $$25.00$).
The spread: The bid-ask spread in this scenario is $$0.02$ ($$25.02 - $25.00$). This represents the immediate cost of crossing the spread if you were to buy and immediately sell, or vice versa.

Practical Applications

The bid and ask are central to several aspects of financial markets:

Order Execution: When investors place buy or sell orders for securities, the bid and ask determine the effective execution price. A broker-dealer is obligated to provide transparent information about order handling practices, including where customer orders are routed and any payments received for order flow¹⁵, ¹⁶, ¹⁷. The Securities and Exchange Commission (SEC) provides investor bulletins to educate the public on various aspects of securities transactions¹³, ¹⁴.
Market Efficiency and Price Discovery: Tight bid-ask spreads are often cited as evidence of an efficient market, where new information is quickly reflected in prices. High-frequency trading (HFT) firms, through their rapid placement and cancellation of orders, are significant contributors to the narrowing of bid-ask spreads, which can reduce transaction costs for all market participants¹⁰, ¹¹, ¹².
Arbitrage Opportunities: Discrepancies in bid and ask prices across different trading venues can create opportunities for arbitrageurs to profit by simultaneously buying low at one venue's bid and selling high at another's ask.
Liquidity Assessment: The width of the bid-ask spread serves as a direct indicator of a security's liquidity. Highly liquid securities, such as major large-cap stocks traded on a major securities exchange, typically have very narrow spreads, sometimes just a penny. Illiquid assets, like certain over-the-counter (OTC) stocks or less frequently traded bonds, may have wider spreads, reflecting less active trading and higher risk for market makers. FINRA's Market Data Center provides valuable information for investors to research market conditions, including data on exchange-traded and OTC equities⁷, ⁸, ⁹.

Limitations and Criticisms

While bid and ask prices are fundamental, their interpretation has certain limitations and has drawn criticism, especially in the context of modern market structures. One significant concern relates to volatility and market stability, particularly during periods of stress or rapid price movements. While high-frequency trading (HFT) can generally reduce bid-ask spreads and enhance liquidity under normal conditions, there are arguments that HFT strategies, which rely on the bid and ask, can exacerbate market instability during extreme events. For instance, some research suggests HFT firms might withdraw liquidity when markets become volatile, leading to wider spreads and increased price swings, as seen in events like the 2010 "Flash Crash"⁴, ⁵, ⁶.

Another criticism revolves around the concept of "payment for order flow," where broker-dealer firms route customer orders to specific market makers in exchange for a fee. This practice, while regulated by the SEC, raises questions about whether customers are always receiving the best possible execution price, even if the quoted bid and ask prices are tight¹, ², ³. The concern is that the profit from the bid-ask spread may be shared with the broker, potentially at the expense of a slightly less favorable execution for the client.

Bid and Ask vs. Last Price

The "bid and ask" refer to the current highest price a buyer is willing to pay (bid) and the current lowest price a seller is willing to accept (ask). These are standing quotes in the order book that represent potential trades.

In contrast, the "last price" refers to the price at which the most recent trade of a security occurred. The last price can be the bid, the ask, or a price in between, depending on how the most recent transaction was executed. For example, if a buyer placed a market order and bought at the current ask, the last price would then be the ask. If a seller placed a market order and sold at the current bid, the last price would be the bid. Confusion often arises because investors might see the last price displayed prominently and mistakenly assume it is the price at which their order will be filled, when in fact, for immediate execution, a buy order will fill at the ask and a sell order at the bid.

FAQs

What is a good bid-ask spread?

A "good" bid-ask spread is generally a narrow one, indicating high liquidity and efficient trading in the stock market. For highly traded equity securities on major exchanges, a spread of just a few cents or even one cent is common. A wider spread suggests lower liquidity and potentially higher trading costs for investors.

How does bid and ask affect my order?

The bid and ask directly impact your execution price. If you place a market order to buy, it will generally be filled at the ask price. If you place a market order to sell, it will generally be filled at the bid price. To avoid buying at the ask or selling at the bid, you can use a limit order, specifying the maximum price you're willing to pay or the minimum price you're willing to receive.

Who sets the bid and ask prices?

The bid and ask prices are continuously set by various market participants, including individual investors, institutional traders, and especially market maker firms. These entities place buy (bid) and sell (ask) orders in the order book, reflecting their willingness to transact at specific prices. The interplay of all these orders determines the prevailing bid and ask.

Why do bid and ask prices change so frequently?

Bid and ask prices change frequently due to the constant flow of new information, shifts in supply and demand, and the continuous interaction of market participants. Factors such as company news, economic data, global events, and algorithmic trading strategies can all lead to rapid adjustments in the bid and ask as buyers and sellers update their willingness to transact. This rapid adjustment is a core component of price discovery.