Bids and asks: Meaning, Criticisms & Real-World Uses

What Is Bids and asks?

Bids and asks are fundamental components of securities trading, representing the two sides of a market quotation for a financial instrument. In the realm of market microstructure, the "bid" is the highest price a buyer is currently willing to pay for a security, while the "ask" (also known as the offer) is the lowest price a seller is willing to accept. The continuous interaction between these bids and asks forms the basis of price discovery in financial markets. Understanding bids and asks is crucial for investors as they reflect the real-time supply and demand dynamics of an asset, influencing the immediate transaction cost of a trade.

History and Origin

The concept of bids and asks has existed since the earliest days of organized markets, evolving from verbal "open outcry" systems to sophisticated electronic trading platforms. Historically, on physical trading floors, specialists or market makers would quote prices at which they were willing to buy (bid) and sell (ask) securities. For instance, on the New York Stock Exchange (NYSE), floor specialists acted as human intermediaries matching buy and sell orders.²³, ²⁴

A significant transformation occurred with the advent of electronic trading in the latter half of the 20th century. In 1971, the NASDAQ (National Association of Securities Dealers Automated Quotations) was established as the world's first electronic stock market, initially functioning as a bulletin board for quotes.²² This technological shift greatly increased the speed and efficiency of price quotation and trade execution, leading to narrower bid-ask spreads over time. For example, average bid-ask spreads for S&P stocks decreased from approximately 50 basis points in 1990 to about 20 basis points by 2000, and further declined to around 0.5 basis points for certain large-cap stocks and exchange-traded funds (ETFs) by 2020, largely due to automated trading technology and regulatory changes like decimalization in 2001.²¹ Decimalization, implemented by the U.S. Securities and Exchange Commission (SEC), reduced the minimum price increment ("tick size") from fractions (like 1/16 of a dollar) to a single cent, further tightening spreads.²⁰

Key Takeaways

Bids and asks represent the highest price a buyer will pay (bid) and the lowest price a seller will accept (ask) for a security.
The difference between the ask price and the bid price is the bid-ask spread, which is a de facto transaction cost.
Market makers profit by buying at the bid and selling at the ask, facilitating liquidity in the market.
A narrow bid-ask spread typically indicates high market liquidity and active trading.
The collective depth of bids and asks at various price levels forms the order book, providing insight into market depth.

Formula and Calculation

While "bids and asks" themselves are simply quoted prices, they are used to calculate the bid-ask spread, which is a key metric in market analysis. The formula for the bid-ask spread is straightforward:

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

For example, if the current ask price for a stock is $50.05 and the bid price is $50.00, the bid-ask spread is $0.05. This spread represents the implicit cost of immediacy for a market order. Investors placing a market order to buy will typically pay the ask price, while those placing a market order to sell will receive the bid price. The revenue of a market maker is often derived from capturing this spread.

Interpreting the Bids and asks

The bids and asks provide a real-time snapshot of supply and demand for a financial instrument. The highest bid and lowest ask define the "inside market" or "National Best Bid and Offer (NBBO)," which represents the best available prices across all active exchanges.¹⁹

A tight bid-ask spread (a small difference between the bid and ask) generally indicates a highly liquid market with many buyers and sellers actively trading the security. This means that an investor can execute a trade quickly without significantly impacting the price. Conversely, a wide bid-ask spread suggests lower liquidity, often found in less frequently traded securities or volatile market conditions. In such scenarios, executing a large trade might lead to significant price slippage, as there might not be sufficient volume at the best bid or ask price to fill the entire order. The "order book" displays bids and asks at various price levels, offering insights into market depth—the market's ability to absorb large orders without significant price impact.

¹⁸## Hypothetical Example

Consider XYZ stock trading on a stock exchange. An investor checks the quote and sees the following bids and asks:

Bid Price: $25.00 (with a size of 500 shares)
Ask Price: $25.05 (with a size of 700 shares)

This means buyers are currently willing to pay up to $25.00 per share, and sellers are willing to sell for as little as $25.05 per share. The bid-ask spread is $0.05.

If an investor wants to buy 100 shares of XYZ using a market order, they would pay the ask price of $25.05 per share, for a total of $2,505. If another investor wants to sell 100 shares of XYZ using a market order, they would receive the bid price of $25.00 per share, totaling $2,500. The broker-dealer facilitating these trades, acting as a market maker, would buy at $25.00 and sell at $25.05, capturing the $0.05 spread per share as revenue. If the investor instead used a limit order, they could specify a price they are willing to pay or receive, which would then be added to the order book if not immediately executable.

Practical Applications

Bids and asks are critical in various aspects of financial markets:

Trade Execution: Investors rely on bids and asks to determine the best available prices for their buy and sell orders. Reputable brokers are obligated to seek "best execution" for their clients' orders, meaning they strive to achieve the most favorable price under prevailing market conditions, considering factors like price, speed, and likelihood of execution. T¹⁷he U.S. Securities and Exchange Commission (SEC) has actively worked to codify and strengthen this "best execution" standard through proposed regulations.
*¹⁴, ¹⁵, ¹⁶ Liquidity Assessment: The tightness of the bid-ask spread is a direct indicator of a security's market liquidity. Securities with narrow spreads are generally more liquid, making them easier and cheaper to trade. This is particularly relevant for institutional investors managing large portfolios or for markets with less transparency, such as the corporate bond market, where bid-ask spreads can vary significantly based on factors like maturity and credit risk.
*¹², ¹³ Algorithmic Trading: High-frequency trading firms and other algorithmic trading strategies heavily utilize bids and asks, along with the full order book data, to identify minuscule price discrepancies and execute trades at lightning speeds, capitalizing on very small spreads.
*¹⁰, ¹¹ Risk Management: Market makers and liquidity providers use bids and asks to manage their inventory risk, adjusting their quotes based on their current holdings and perceptions of market volatility and order flow.

Limitations and Criticisms

While bids and asks provide crucial market information, they have limitations:

Market Depth: The visible bids and asks only represent the "top of the book"—the best prices currently available. They do not fully convey the total volume of buy and sell orders at various deeper price levels, known as market depth. A seemingly tight spread might hide shallow depth, meaning a large order could "walk the book" and execute at progressively worse prices.
⁸, ⁹ Hidden Orders: Some market participants utilize hidden orders or dark pools, which are not displayed in the public order book, making the visible bids and asks an incomplete picture of total market interest.
Market Fragmentation: The proliferation of multiple trading venues can lead to market fragmentation, where the same security trades on different exchanges. This can complicate price discovery and impact the efficiency of bids and asks, potentially leading to wider effective spreads or increased search costs for liquidity, particularly for smaller stocks.
⁴, ⁵, ⁶, ⁷ Volatility and Adverse Selection: In highly volatile markets, bid-ask spreads tend to widen as market makers face increased risk. Academic research suggests a strong correlation between bid-ask spread and price volatility per trade, indicating that a significant portion of the spread can be attributed to adverse selection risk, where market makers face traders with superior information.

##¹, ², ³ Bids and asks vs. Bid-Ask Spread

The terms "bids and asks" and "bid-ask spread" are closely related but refer to distinct concepts. "Bids and asks" are the individual prices themselves: the price buyers are willing to pay (bid) and the price sellers are willing to accept (ask). They represent the active supply and demand for a security at a specific moment. The "bid-ask spread" is the difference between these two prices. It is a quantitative measure of liquidity and an implicit transaction cost. While bids and asks are the raw data points, the bid-ask spread is a derived metric that provides insight into market efficiency and the cost of trading. A narrow spread indicates a more liquid and efficient market, whereas a wider spread suggests less liquidity and higher transaction costs.

FAQs

What is the purpose of bids and asks in trading?

Bids and asks serve as the fundamental mechanism for price discovery in financial markets, indicating the current highest price a buyer is willing to pay and the lowest price a seller is willing to accept. They enable transparent and efficient trading by showing the immediate executable prices for a security.

Who sets the bids and asks?

Bids and asks are typically set by market participants, including individual investors, institutional traders, and market makers. Market makers specialize in quoting both buy and sell prices to facilitate trading and provide liquidity, profiting from the bid-ask spread.

How do bids and asks relate to stock price?

The "last traded price" is often considered the current stock price, but it is a historical data point. Bids and asks represent the current, real-time potential transaction prices. A buy order will be executed at the ask, and a sell order at the bid. The actual transaction price will fall between the highest bid and the lowest ask, or at those levels.

Does a narrow bid-ask spread always mean a good investment?

A narrow bid-ask spread indicates high liquidity and lower transaction costs, which is generally favorable for trading. However, it does not inherently signify a "good investment." Investment quality depends on a multitude of factors, including a company's fundamentals, growth prospects, industry trends, and overall market conditions, not just the trading characteristics of its shares.