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Bid and Ask Volume, Imbalances and Double-Counting

Thomas Lepri

First up is Aline Henderson, who writes, "What, if anything, is the meaning of a stock's bid and ask sizes? When I pull up real-time quotes on my on-line broker's Web site, it always gives me those two numbers along with the current quote." Aline, to crudely paraphrase the Scottish economist Adam Smith, it all comes down to two forces: supply and demand. And for traders, the volume of a stock's bid and ask prices provide a third dimension that brings those abstract concepts to life.

Imagine a stock with a bid (current highest buying price) for 1,000 shares at 10 1/8, and an ask (current lowest selling price) for 5,000 shares at 10 3/8. There's more volume on the ask side than the bid side in this situation, effectively putting downward pressure on the stock price.

Here's how it works. If you put in a market order to buy 1,500 shares, your order would be filled at the ask of 10 3/8, leaving 3,500 more shares for sale at that price. But a market order to sell the same number of shares would actually knock the price of the stock down. A market order to sell 5,000 shares couldn't be filled at the bid, which is only for 1,000 shares. The remaining 500 shares would have to be filled at the next best bid, say at 10 1/16. In other words, the bid would "tick down."

The problem is that this information expires very quickly, and doesn't give you any idea of the buying and selling volume behind the current bid and ask. On the New York Stock Exchange, only the specialist has this information, which he keeps in his or her "book." Things are a bit different on the Nasdaq, where several market makers compete in each stock. The electronic communications networks used by brokerages and day trading firms offer a window into this world through the wonder of Level II order flow data, which includes the volume and prices of the mountain of bids and asks behind the quotes you pull up on Yahoo! (YHOO Quote) or Ameritrade (AMTD Quote).

Message Center

• Memo to Calvin Lui, who wonders what it means when trading in a stock is halted or delayed because of "imbalance": On the NYSE and the American Stock Exchange, it's normally the job of the specialist to provide liquidity -- that is, to ensure that buyers and sellers can easily find someone to take the other side of their trades. When no one's there to take that side, the specialist steps in and trades stock from his or her own inventory.

  But sometimes things get a little too out of hand. If there are too many buy or sell orders for an orderly market to be maintained, the exchange will declare the stock to be in "imbalance." If this happens before the open, the exchange delays trading until the specialist can line up matching orders. During trading hours, trading in such a stock is suspended until liquidity returns. But ironically, the most volatile sectors -- the Internet and technology sectors -- trade on the Nasdaq, which, because of logistical difficulties associated with its competitive market maker system, has never halted or delayed trading in a stock because of imbalance.

• Memo to Howard Lorch, who wonders what the deal is with double-counting on the Nasdaq: How the Nasdaq counts its trades has been something of a hot-button issue ever since it surpassed the NYSE as the busiest stock exchange. In fact, concerned with what it saw as excessive transaction fees, the Securities Exchange Commission last year pressured the National Association of Securities Dealers to approve a resolution eliminating the practice of double-counting what are known as "riskless principal" transactions, in which market makers match buy and sell orders without risking any of their own capital. This resolution, which would affect anywhere from 3% to 11% of Nasdaq trades, is still under review at the SEC.

  NASD spokesman Mike Shokouhi says that, besides these "riskless principal" trades, there's really no difference between how the Nasdaq and the NYSE count volume. All trades made by Nasdaq market makers to adjust their inventory are recorded once, just as they are with NYSE specialists. Shokohui chalks up the difference between Nasdaq and NYSE volume to the ascendancy of the technology sector. At the same time, each Nasdaq stock has several market makers trading for their own accounts, while the market for each NYSE issues is made by a single specialist.

• Memo to Dale Petts, who, after reading about the pitfalls of trading for dividends in this column two weeks ago, wonders whether it's possible to short a stock about to pay a dividend, knowing that the stock is going to go down by the dividend amount. Geez, Dale! Would you try to cheat your broker like that? Seriously, though -- when you borrow stock from a brokerage for shorting, you're liable for any dividends declared on that stock.