TheStreet

Investing in stocks is a proven way to create wealth, with the Standard & Poor's 500 generating double-digit returns in eight of the past 10 years.

A key component of stock market investing is the trading of stocks and funds, a process often handled by brokers, specialists and market makers, working in tandem with individual stock exchanges.

In executing stock and fund trades, investors need to understand the concept of bid versus ask, which defines the supply and demand for a specific financial asset.

If you want to trade securities at a maximum advantage, getting a good grip on bid versus ask should be a priority.

What Is the Bid-Ask?

The bid-ask on stocks, also known as the "spread" is the difference between a stock's bid price and its ask price. Individual stock exchanges like the New York Stock Exchange or NASDAQ work with stock specialists and brokers to set a security's bid and ask.

The bid-ask spread is also the key in buying a security for the best possible price.

Normally, the ask price is higher than the bid price, and the spread is what the broker or market maker earns in profit from managing a stock trade execution.
In essence, the bid is the price that an investor is willing to pay to buy a particular stock, at a given time, and the ask is the price for which an investor is willing to sell a stock at a specific point in time.

For example, you might be considering a stock in ABC Corporation, which has a bid price of $25 and an ask price of $26.75 per share. In that scenario, the bid-ask spread is $1.75.
The bid-ask spread only impacts individual stocks and not mutual funds that include stocks, as well. That's because mutual funds only set their prices once a day and investors pay the same price to buy or sell a fund.

Understanding the bid-ask spread when trading stocks is critical in getting the best price, either as a buyer or a seller. That's especially the case with stocks that aren't traded that often (i.e., "less liquid" securities), where bid-ask spreads are wider, and thus more impactful on trade executions.

It's understandable that investors may scratch their heads over the math behind the bid-ask spread. After all, in a bid-ask scenario, the buyer is being asked to pay the higher price (the ask) and the seller is being asked to accept the lower price (the bid.)

Let's see how that works in the real world, with the following examples.

Bid-Ask Spread Examples

The reality is that most investors won't see much of an impact on bid-ask spreads, especially if they're trading higher-profile, highly-liquid stocks where the bid-ask spreads are tighter and where buyers and sellers aren't as impacted by bid-ask spreads.

Highly liquid stocks. Consider the bid-ask price on 3M Company (MMM - Get Report) , a highly-traded large capitalization stock. A current glimpse (and the bid-ask does change all the time) has the stock's bid at $189.24 and the ask is at $189.28 - for a bid-ask spread of four cents.

Low liquidity stocks. Or, consider a stock that doesn't trade that often - we'll call it XYZ Corp. This stock, which doesn't trade often has a bid of $9 per share and an ask of $10.50 per share, for a wider spread of $1.50.

Usually, while investors can find low-liquidity stocks in all corners of the financial markets, you'll find them mostly in the small-capitalization (small cap) sector, or lightly-traded exchange-traded funds (ETFs), where stocks don't trade as often as large, more liquid stocks like 3M.

Low-liquidity stocks and funds also have wider spreads for a unique reason.

The bid-ask spread is how a broker or market makes a profit on a trade execution - the price the stock specialist charges for efficiently and quickly matching up buyers and sellers.

When stocks and funds don't trade as often, the market specialist works harder to match up buyers and sellers, usually with a security that trades with higher volatility. For that extra effort, the broker or market maker charges a markup to investors, for the extra work - and the extra price risk - they're taking on.

Six Big Takeaways on Bid-Ask Spreads

Once fully explained, the concept of bid and ask becomes easier for investors to understand, and to apply the spread into their trading decisions.

In doing so, though, make sure you're taking these key points on bid-ask spreads into consideration:

  1. The bid price is the highest price a securities buyer will pay.
  2. The ask price is the lowest price a securities seller will accept.
  3. The ask price is often referred to as the "offer price."
  4. When a bid price overlaps an ask price, a trade is usually executed.
  5. The more liquid a stock or fund is, the narrower is its bid-ask spread. Conversely, the lower the liquidity of a stock or fund, the wider the bid and ask spread. It's not uncommon for widely traded stocks like Google (GOOG - Get Report) to have a bid-ask price of a single penny.
  6. Perhaps the biggest driver of bid and ask spreads - besides liquidity - is supply and demand. The more a stock or fund is in demand, the narrower its spread. Highly volatile sticks can move bid and ask spreads around significantly, as well.

Types of Stock/Fund Execution Orders

Investors looking to take advantage of bid-ask spreads can do so with the following types of trade orders, all issued to brokers, specialists or market makers.

  • Market order. This is a trade order to buy or sell a stock or fund on an immediate basis. A specialist will guarantee the order is executed, but will not guarantee the price the trade is executed at. Bid and ask-wise, a market order will be executed at or near the standing bid and ask level when buying or selling a stock or a fund. A note: investors shouldn't anticipate executing a trade order at the price they see on sites like TheStreet.com. Stock prices change all the time, and the last-traded price is not always the price where the trade is executed.
  • Limit order. This type of order allows for the buying and selling of a stock or a fund at a specific price, or better. There are variances with limit orders and investors should know them. For example, a buy limit order is only executed at the security's limit price - or lower. Let's say you place a limit order to buy shares of XYZ Corp. at no higher than $20 per share. In that scenario, the order can only be executed if the share price is $20 or lower.
  • Stop order. A stop order, or "stop-loss" order is an order to buy or sell a stock or fund once the security hits a specific price level. That level, known as the stop price, leads to an executable trade once the stop order reaches that level, and is executed as a limit order.
  • Buy stop order. A buy stop order is a stop price execution order where the price is higher than the current market price for a stock or a fund. A buy stop order is a useful tool to limit a loss on the security that the investor has sold short.
  • Sell stop order. Conversely, a sell stop loss order is executed at a stop price that is lower than the current market price for the security. Sell stop orders are often put into play to limit a loss on a security, or to safeguard profits already earned on a security.

The bid and ask spread is a vital component to trade executions and getting to know bid and ask makes you a better investor and a more knowledgeable trader.

Get to know how bid and ask is applied, and how specific trader orders can be leverage to get a better execution price.